March 04, 2015
Section 1519 was passed as part of the Sarbanes-Oxley Act in the wake of Enron’s massive accounting fraud. The section was designed to fill a gap in the law by preventing corporate document-shredding to conceal evidence of financial wrong doing. Prior law under Section 1512(b) prevented intimidating, threatening or corruptly persuading another person to shred documents. Section 1519 precludes shredding by a person. The government and the defendant in Yates v. United States, No. 13-7451 (S.C. 2015) agreed on these points. What the parties could not agree on was whether destruction of any tangible object such as a fish is covered by Section 1519.
The facts Yates are straight forward. John Yates is a commercial fisherman. While fishing in federal waters in the Gulf of Mexico on his vessel Miss Katie he caught undersized grouper. Mr. Yates got caught. By the time he made , however, there were no undersized grouper to be found on the Miss Katie. The undersized fish had been returned to the sea. After months of delay the government prosecuted Mr. Yates, claiming violations of Sections 1519 and 2232(a). The latter precludes the destruction or removal of property to prevent seizure. The former, provides in pertinent part that “Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a fake entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the proper administration of any matter within the jurisdiction of any department or agency of the United States . . .” may be fined or imprisoned for up to twenty years.
At mid-trial Mr. Yates moved for acquittal. He argued that in view of the origin, title and purpose Section 1519 focuses on document destruction. Its reference to tangible objects subsumes computer hard drives, log books and similar items but not fish, according to Mr. Yates. The Government countered, arguing that tangible objects are things other than records. The District Court rejected the motion. Mr. Yates was convicted on both charges but only appealed the one based on Section 1519. The Eleventh Circuit affirmed.
The Supreme Court reversed. A plurality opinion authored by Justice Ginsburg and joined by the Chief Justice and Justices Breyer and Sotomayor, concluded that SOX was “designed to protect investors and restore trust in financial markets following the collapse of Enron Corporation. A fish is no doubt an object that is tangible . . . But it would cut Section 1519 loose from its financial-fraud mooring to hold that it encompasses any and all objects, whatever their size or significance, destroyed with obstructive intent . . . A tangible object captured by Section 1519, we hold, just be one used to record or preserve information.” Justice Alito concurred in the result while Justices Scalia, Kennedy and Thomas joined Justice Kagan in dissent.
Justice Ginsburg began by stating that whether a “statutory term is unambiguous . . . does not turn solely on dictionary definitions of its component words.” Rather, the question is one of context because “[i]n law as in life . . .the same words, placed in different contexts, sometimes mean different things.” When “[f]amiliar interpretive guides” are applied, the meaning of the phrase “tangible object” becomes clear, the Justice wrote.
Here the caption of Section 1519 is “’Destruction, alteration, or falsification of records in Federal investigations and bankruptcy.’” This does not suggest that the section governs all physical evidence “however remote from records.” This reading is bolstered by considering the fact that Congress placed Section 1519 and its companion provision at the end of the chapter following Sections 1516 and 1517, each of which prohibits obstructive acts in specific contexts. At the same time Congress did not direct the codification of SOX’s other additions to Chapter 73 adjacent to these specialized provisions.”
The words surrounding “tangible object” in the section give further support to the reading adopted by the Court. The phrase “’falsifies, or makes a false entry in any record[or]document’ – also cabin the contextual meaning of that term” according to the opinion. Indeed, since the phrase is the last in a list of terms that starts with “record” or “document” the “term is therefore appropriately read to refer, not to any tangible object, but specifically to the subset of tangible objects involving records and documents, i.e., objects used to record or preserve information.”
Finally, the rule of “lenity” confirms the conclusion reached based on traditional cannons of construction. That principle is relevant here “where the Government urges a reading of Section 1519 that exposes individuals to 20-year prison sentences for tampering with any physical object that might have evidentiary value in any federal investigation. . .” (emphasis original). Before adopting the “harsher alternative” it is appropriate “to require that Congress should have spoken in language that is clear and definite.”
Justice Kagan, in dissent, began by noting that “[a]fish is, of course, a discrete thing that possesses physical form,” citing Dr. Seuss, One Fish Two Fish Red Fish Blue Fish (1960). “So the ordinary meaning of the term ‘tangible object’ in Section 1519, as no one here disputes, covers fish (including too-small red grouper).” At the same time, context matters as the plurality notes.
Section 1519 contains a “laundry list of verbs” which are “supposed to ensure – just as ‘tangible object” is meant to – that . . . [it] covers the whole world of evidence-tampering, in all its prodigious variety.” Indeed, Congress could only achieve its objective of preventing the destruction of evidence by avoiding overly technical legal distinctions. Accordingly, the phrase tangible object must be read broadly.
March 03, 2015
Trading suspensions, market manipulation and Ponzi scheme actions – staples of SEC enforcement. The Commission suspended trading for 128 dormant shell companies this week while bringing a market manipulation action involving two recidivists and a case against an adviser involving Ponzi like schemes.
Trading suspensions: The suspensions which halted trading in the shares of 128 issuers described as being dormant by the Commission are part of Operation Shell-Expel. Since that operation began in 2012 trading suspensions have been issued for over 800 microcap stocks. That represents about 8% of the OTC traded stocks. While trading could begin again if certain requirements are met, it is “extremely rare” for that to occur, according to the Commission.
Manipulation: The Commission filed a pump-and-dump and insider trading action centered on the manipulation of the shares of a company which is a defendant in another SEC enforcement action by a securities law recidivist. SEC v. Williky, Civil Action No. 15-cv-357 (S.D. Ind. Filed March 2, 2015). This action focused on the manipulation of the shares of Imperial Petroleum, Inc. by Gary Williky. The firm, a defendant in another SEC enforcement action, supposedly made and sold biofuel, reaping significant tax credits in the process. Mr. Williky, a defendant in two prior SEC enforcement actions, was retained to conduct investor relations.
Following his retention, Mr. Williky engaged in a series of wash sales and matched orders to inflate the price of the shares. He also used e-mails in which he touted the shares without disclosing that he was actually selling the stock. Although at one point he acquired over 5% of the company shares, the required disclosure schedules were not filed.
During his work with the company Mr. Williky discovered that its business was a fraud. The company did not manufacture bio-fuel. It purchased the substance and resold it. Accordingly, it was not entitled to the tax credits it obtained. Rather than report the fraud to the authorities, Mr. Williky demanded and obtained a block of stock from the firm in return for his silence. He then sold the shares into the market. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 9(a)(1), 10(b) and 13(d). The case is pending. See Lit. Rel. No. 23211 (March 2, 2015).
Ponzi payments: The Commission also brought an action against fund manager Gregory Gray and his controlled entities, Archipel Capital LLC and BIM Management LP, centered on a Ponzi like scheme. SEC v. Gray, (S.D.N.Y. Filed February 27, 2015). Since at least 2011 Mr. Gray has raised about $20 million from at least 140 investors for various funds he controls. Although each fund was supposed to be separate, the investor money was comingled and transferred among the group.
The Social Media Fund LP, one of the group of funds, was supposed to acquire pre-IPO shares of Twitter at prices ranging from about $19 to $25 per share. Mr. Gray raised about $5.2 million for this fund. While about 80,000 pre-IPO shares of Twitter were acquired, under the terms of the offering documents about 230,000 should have been acquired. When investors sought the transfer of the promised shares Mr. Gray at first delayed. He then misappropriated about $5.3 million from the Late Stage Fund LP, another member of the group. That Fund was supposed to acquire pre-IPO shares of Uber Technologies, Inc. Rather than use the investor money put in the Late Stage Fund primarily by one investor to purchase Uber shares, Mr. Gray diverted to repay investors in the Social Media Fund. When the investor in the Late Stage Fund demanded the shares, Mr. Gray fabricated certificates for the investor. In testimony before the staff he authenticated the shares.
To replace the funds in the Late Stage Fund Mr. Gray continued soliciting investors. In February 2015 he secured $470,000 from another investor for that Fund. He also claimed to be about to close a deal with a China based investor for an additional $30 million. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 206(4). The SEC obtained an emergency freeze order. The case is pending.
March 02, 2015
The percentage of M&A deals challenged by shareholder suits remained largely constant last year while the number of suits filed against each deal declined slightly, according to a recent report by Cornerstone Research (here). In 2014 about 93% of the deals were challenged in litigation compared to 94% in the prior year and 93% in 2012 and 2011. The number of suits per deal declined in 2014 declined however. Last year there were 4.5 suits filed per deal. That compares to 5.2 in 2013, 4.8 in 2012 and 5.4 in 2011.
The most litigated deal in 2014 was the Fusion-io Inc./SanDisk Corporation transaction, challenged in 22 suits. The International Game Technology/GTECH S.p.A. deal was next with 21 suits followed by the Safeway Inc. buyout at 14 and American Realty Capital Healthcare Trust Inc.,/Ventas Inc. with 13 complaints. None of the transactions last year were among the most litigated deals over the last seven years. Those were: The 2008 Genentech Inc. transaction which was challenged in over 30 suits; the 2010 Dynegy Inc. deal which drew 29 suits; and the 2013 Dell Inc. buy-out which was the subject of 26 shareholder complaints.
In contrast with prior years, during 2014 60% of the M&A suits were filed in one jurisdiction. This is the reverse of prior years and is probably the result of forum selection clauses, according to the report. Only four percent of the deals were challenged in more than three jurisdictions, down from the peak of 20% in 2011. The cases were concentrated in five jurisdictions: Delaware where 74 cases were filed; California at 22; New York at 10; Maryland at 10; and Michigan with 6.
Most of the M&A suits continued to be resolved by closing, although the percentage declined in 2014. Last year 59% of the suits were resolved by closing compared to 74% in 2013, 78% in 2012 and 73% in 2011. In 2014 only one suit went to trial. That action arose from the 2011 buyout of Rural/Metro Corp. by Warburg Pincus LLC. RBC Capital Markets LLC went to trail and was found liable for planning to provide financing to the acquirer without disclosing that fact to the Rural/Metro directors. The court awarded $75.8 million in damages.
Finally, of the 78 settlements reached in 2014 for which Cornerstone had data, only 6 involved the payment of monetary consideration. About 80% of the settlements reached in 2014 provided only for disclosure. In contrast, the dollar value of two of the three largest settlements involving a monetary component in 2014 exceeded the largest settlement from 2013. Last year Plans Exploration & Production Co., a 2012 deal, settled with a payment of $137.5 million, Jefferies Group LLC, also a 2012 transaction, resolved with a payment of $70 million and the suit involving the 2013 Garnder Denver Inc. deal concluded with the payment of $29.0 million. In contrast, in 2013 the largest settlement was $42.7 million arising out of the 2010 CNX Gas deal while the second and third largest payments were tied to the 2013 BMC Software Inc. deal which settled at $12.4 million and the Infogroup deal from 2010 that concluded with a payment of $13.0 million.
March 01, 2015
Cooperation was a key factor in the resolution of an action involving a minority owner of a broker-dealer that is alleged to have facilitated a fraudulent scheme to conceal losses at a major Japanese company. In the Matter of Hajime Sagawa, Adm. Proc. File No. 3-16412 (February 27, 2015).
Hajime Sagawa was a registered representative, a founding member, minority owner and a director of Axes America, LLC, from 1997 through 2008. The firm was a Commission registered broker-dealer from 1997 through 2008 when it voluntarily withdrew its registration.
This proceeding centers on efforts to conceal millions of dollars in losses at Olympus Corporation, a manufacturer and seller of cameras, microscopes, endoscopes and other medical equipment. Shares of Olympus are listed on the Tokyo Stock Exchange.
To conceal certain operating looses sustained in the mid-1980s Olympus supplemented its income with speculative investments. When the Japanese economy took a down turn in 1990 Olympus sustained significant losses on those investments. Executives 1 and 2 then moved the investments into trusts constructed under Japanese law. Those trusts were managed in such a way that write-downs could be avoided for a time.
Eventually the losses in the trusts reached the point where write-downs loomed. At that time the two executives moved the asses to off-balance sheet entities in the Cayman Islands and British Virgin Isles. Through a series of transactions Olympus claimed to have “sold” the poor investments to the off-balance sheet entities. The complexity of the transactions resulted in advisory, legal and banking fees that eclipsed the investment losses.
Following the completion of the transactions, Olympus needed to create a mechanism to repay the banking entities that financed the sales. The two executives planned to accomplish this by diverting portions of the payments that would be made for the next acquisition by Olympus to the banks.
To implement the scheme, one of the two executives executed an investment banking agreement with Axes after meeting with Mr. Sagawa. Under the terms of the agreement Axes would serve as financial adviser for the acquisition of two possible targets. The agreement called for an outsized investment banking fee.
Talks with one possible acquisition target broke down. Olympus then identified Gyrus Group PLC, a U.K firm that specialized in endoscopes as a possible target. Following the closing of that deal in February 2008 Olympus paid Axes an advisory fee in the form of cash and Gyrus preference shares valued at about 38% of the purchase price. Two years later Olympus purchased those shares from Axes and an affiliate. The $662 million purchase price, along with other portions of the fees paid to the broker-dealer, were channeled to the off-balance sheet entities to repay the bank loans.
The Order alleges violations of Securities Act Sections 17(a) and (c) and Exchange Act Sections 15(c)(1)(A). It also acknowledged the cooperation of Respondent.
Mr. Sagawa resolved the proceeding, consenting to the entry of a cease and desist order based on the Sections cited in the Order. He will also be barred from the securities business and from participating in any penny stock offering. No penalty was imposed in view of Respondent’s cooperation.
February 26, 2015
Four SEC Commissioners addressed the annual SEC Speaks Conference, reviewing recent agency initiatives and tracing potential paths for the future. The SEC also brought another FCPA action, a misappropriation case and an action centered on a failed audit of a broker-dealer that is now defunct.
Remarks: SEC Chair White and Commissioners Kara Stein, Michael Piwowar and Daniel Gallagher each addressed the SEC Speaks Conference (here and here).
SEC Enforcement – Filed and Settled Actions
Statistics: During this period the SEC filed 1 civil injunctive action and 3 administrative proceedings, excluding 12j and tag-along-actions.
Illegal distribution: SEC v. Lefkowitz, Civil Action No. 8:12-cv-1210 (M.D. Fla.) is a previously filed action against, among others, Unico, Inc., Mark Lopez, Steven Peacock and Shane Traveller. The complaint alleged that the defendants engaged in the unregistered distribution of billions of shares of penny stocks through the repeated misuse of the exemption from registration contained in Section 3(a)(10) which permits a public company to issue common stock to public investors without a registration statement to settle bona fide debts and other claims. This week the Court entered final judgments against the four defendants prohibiting future violations of Securities Act Sections 5(a) and 5(c) and Exchange Act Section 13(d). In addition, Unico will pay disgorgement of $9,350,000 along with prejudgment interest for which payment of all but $250,000 is waived along with any penalty based on financial condition; Mr. Lopez agreed to a penny stock bar but no penalty was imposed based on financial condition; Mr. Peacock will pay disgorgement of $609,763 and prejudgment interest, all of which was waived along with any penalty based on financial condition and he will return certain shares of stock; and Mr. Traveller agreed to the entry of a penny stock bar and will pay disgorgement of $169,369 and a civil penalty of $52,000. See Lit. Rel 2206 (February 24, 2015).
Fraudulent scheme: SEC v. Heart Tronics, Inc., Civil Action No. 11-1962 (C.D. Cal.) is a previously filed action against the company, attorney Mitchell Stein and others centered on a fraudulent scheme. This week the Court granted partial summary judgment against Mr. Stein and in favor of the SEC based on his criminal conviction on 14 counts of conspiracy to commit mail fraud and wire fraud, mail fraud, wire fraud, securities fraud, money laundering and conspiracy to obstruct justice. The court found violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). It entered permanent injunctions, officer and director and penny stock bars and ordered the payment of a civil penalty of $5,378,581.61, and disgorgement and prejudgment interest of $6,076,415.52. See Lit. Rel. No. 23205 (February 23, 2015).
Improper professional conduct: In the Matter of Halpern & Associates LLC, Adm. Proc. File No. 3-16399 (February 23, 2015) is a proceeding which names as Respondents the audit firm and its owner and president, Barbara Halpern. She also served as the engagement partner for the 2009 audit of Lighthouse Financial Group, LLC, a registered broker-dealer that is now in liquidation. The Order alleges that the financial statements of Lighthouse for the year ended December 31, 2009 were materially inaccurate. Those statements overstated the firm’s assets since the value of its securities inventory was erroneous and inflated. In addition, its liabilities were understated because obligations to a broker-dealer through which the firm engaged in proprietary trading was omitted. As a result the firm’s net capital was overstated by about 350%. Respondents audit failed to detect these errors and failed to conform to GAAS. The Order alleges violations of Exchange Act Section 17 and Rule 17a-5(a)(iv)(B) as well as various auditing provisions relating to planning the engagement, exercising due professional care, confirmations and professional conduct. The matter will be set for hearing.
Investment fund fraud: SEC v. GLR Capital Management LLC, Civil Action No. 12-cv-2663 (N.D. Cal.) is a previously filed action against John Geringer and the company. It alleged the operation of a Ponzi scheme. Following the entry of a guilty plea by Mr. Geringer in a parallel criminal action the two defendants resolved the case with the SEC. The Court entered, by consent, permanent injunctions based on Securities Act Section 17(a) and Exchange Act Sections 10(b) and 26 along with Advisers Act Sections 206(1), 206(2) and 206(4). The Court also ordered the payment of disgorgement and prejudgment interest, on a joint and several basis, of $2,772,475 which will be satisfied by the restitution and forfeiture order in the parallel criminal case. In a related action Mr. Geringer consented to the entry of a bar from the securities business. See Lit. Rel. 23204 (February 23, 2015).
Misappropriation: SEC v. Premier Power, LLC, Civil Action No. 15-cv-1248 (S.D.N.Y. Filed February 20, 2015) is an action against the company, its Chairman, Jerry Jankovic, and his son, CEO John Jankovic. After raising about $1.95 million for energy related projects for the company, the defendants diverted about $1 million to cover the costs of an unrelated lawsuit against Jerry Jankovic and a business associate, Sandra Dyche. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). It also alleges control person liability as to Jerry Janovic under Exchange Act Section 20(a). The case is pending. See also In the Matter of Sandra Dyche, Adm. Proc. File No. 3-16398 (February 20, 2015)(Ms. Dyche settled the action, consenting to the entry of a cease and desist order based on Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a) and agreeing to pay disgorgement and prejudgment interest of $1,164,000 and a civil penalty of $250,000; the settlement also prohibits her from soliciting or accepting funds in any unregistered securities offering for five years in addition to other restrictions). See Lit. Rel. No. 23203 (February 20, 2015).
Investment fund fraud: U.S. v. Perkins (E.D. N.Y.) is an action in which Frank Perkins, formerly the CFO of Harbor Funding Group, Inc., was sentenced to serve 9 years in prison after pleading guilty to two counts of conspiracy to commit wire fraud and conspiracy to commit securities fraud and wire fraud. The charges were based on two schemes. In one victims of Hurricane Katrina were defrauded out of over $9 million through a claimed loan arrangement which required the investors to put 10% of the loan in a supposedly secure account. The funds were immediately misappropriated. In the second he engaged in a gold mine investment scheme. Investors were told that the firm would mine gold and other precious metals on Sitkinak Island in Alaska. Through various presentations, cold calls and webinars Mr. Perkins and others convinced investors to purchase shares in their firm. Almost $1 million was raised which went to Mr. Perkins and his confederates.
In the Matter of Goodyear Tire and Rubber Company, Adm. Proc. File No. 3-16400 (February 24, 2015). The action focuses on the period from 2007 through 2011 and involves the payment of bribes by two subsidiaries, one in Kenya and the other in Angola. In Kenya Goodyear acquired a local business by purchasing a minority stake in 2002 and later taking control. During the period the management regularly authorized and paid bribes to employees of government owned or affiliated entities and private companies to obtain business beginning before the firm was acquired. Overall about $1.5 million in bribes were paid in connection with the sale of tires. Goodyear did not detect or prevent the payments because it failed to conduct adequate due diligence when acquiring the firm.
In Angola the company set up a subsidiary in 2007 Over the same time period the subsidiary paid over $1.6 million in bribes to employees of government owned or affiliated entities and private companies to obtain tire sales. The bribes were paid to a variety of entities. The scheme was instituted by the former general manager of the subsidiary. To conceal the payments the firm falsely marked-up the costs of its tires by adding to the invoice price phony freight and customs clearing costs. The scheme was not detected because Goodyear failed to implement adequate FCPA compliance training and controls over the subsidiary. The Order alleges violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). To resolve the proceeding the firm consented to the entry of a cease and desist order based on the Sections cited in the order. It also agreed to pay disgorgement of $14,122,525 along with prejudgment interest. No penalty was imposed in view of Goodyear’s cooperation. The firm will, however, report to the Commission for three years and submit a report within one year which includes a complete description of its FCPA and anti-corruption remedial efforts.
Disclosure/advertising: Equity Trustees Ltd. and Como Financial Services Pty Ltd. were each fined $20,400 in relation to the promotion of the Good Super superannuation fund. The Australian Securities and Investment Commission was concerned that investors would be mislead by solicitations for Good Super and were not being told about fees to exit and withdraw and current insurance entitlements that might be lost.
Suitability: The ASIC banned David Wilkins, formerly of RBS Morgans Ltd., Romad Financial Services Pty Ltd and later MDS Financial Planning Pty Ltd. During the period he solicited clients to participate in his Options Strategy. He represented to clients that trading options carried little or no risk while failing to evaluate their personal circumstances for such trading.
Internal controls/AML: He Zhi Hau, the former CEO of Ping An of China Securities (Hong Kong) was barred from the securities business for 12 months, reprimanded and fined $6 million. The Securities and Futures Commission concluded that the firm failed to have in place sufficient AML procedures or to provide adequate training to its staff and that there were insufficient procedures in place to protect client funds.
February 25, 2015
Goodyear Tire and Rubber Company settled FCPA books and records and internal control charges with the SEC. The settlement reflects the extensive cooperation and remedial efforts of the company. In the Matter of Goodyear Tire and Rubber Company, Adm. Proc. File No. 3-16400 (February 24, 2015).
The action focuses on the period from 2007 through 2011 and involves the payment of bribes by two subsidiaries, one in Kenya and the other in Angola. In Kenya the company acquired a local business by purchasing a minority stake in 2002 and later taking control. During the period the management regularly authorized and paid bribes to employees of government owned or affiliated entities and private companies to obtain business.
The scheme began before Goodyear acquired the firm. The general manager and finance director conducted the scheme. They approved payments for phony promotional products in cash. The staff of the subsidiary then used the cash to make improper payments to employees of customers which included government and private entities. Overall about $1.5 million in bribes were paid in connection with the sale of tires. Goodyear did not detect or prevent the payments because it failed to conduct adequate due diligence when acquiring the firm.
In Angola the company set up a subsidiary in 2007 Over the same time period the subsidiary paid over $1.6 million in bribes to employees of government owned or affiliated entities and private companies to obtain tire sales. The bribes were paid to a variety of entities.
The former general manager of the subsidiary instituted the scheme. To conceal the payments the firm falsely marked-up the costs of its tires by adding to the invoice price phony freight and customs clearing costs. The scheme was not detected because Goodyear failed to implement adequate FCPA compliance training and controls over the subsidiary. The Order alleges violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B).
The SEC acknowledged the extensive cooperation of the firm. This included halting the payments after learning about them and reporting to the Commission. Significant cooperation was provided to the Commission staff. The firm also divested its ownership of the subsidiary in Kenya and is in the process of selling its subsidiary in Angola. In addition, Goodyear undertook disciplinary action against certain employees and implemented improvements to its compliance programs.
To resolve the proceeding the firm consented to the entry of a cease and desist order based on the Sections cited in the order. It also agreed to pay disgorgement of $14,122,525 along with prejudgment interest. No penalty was imposed in view of Goodyear’s cooperation. The firm will, however, report to the Commission for three years and submit a report within one year which includes a complete description of its FCPA and anti-corruption remedial efforts.
February 24, 2015
Yesterday’s article reviewed the remarks of SEC Chair Mary Jo White and Commissioner Kara M. Stein at SEC Speaks. The article today reviews the remarks at the conference of Commissioners Michael S. Piwowar and Daniel M. Gallagher. Collectively, the comments of the Commissioners provide insight into the future path of the agency.
Commissioner Michael S. Piwowar discussed the overall path of the SEC moving forward through the lens of its mission regarding the markets – to be fair, orderly and efficient. First, the Commissioner discussed “fair” in the context of rule making as well as litigation. Fairness in rule making demands that the SEC not act arbitrarily or capriciously. Accordingly, the agency “must ensure that the rules do not change day-to-day on the whims of the Commission and/or its staff. This means that under the Administrative Procedure Act the Commission must not adopt an new rule or rule amendments without proper notice and the opportunity for comment by the public. The corollary of this principle is that the Commission and its staff must not engage in rule making by enforcement or through examinations of regulated entities. For example, we must resist the temptation to include undertakings in enforcement settlements or principles in examination reports that serve as de facto rule requirements.”
Fairness also dictates that in rule making the Commission examine the length and complexity of its releases for new rules. Many of these run 500 or 1,000 pages and are extremely complex. Such releases suggest “that rather than merely explaining our rules, those documents now include extensive guidance akin to rule making, which can create entirely separate fairness concerns. For example, the most recent amendments to our money market funds include key guidance akin to rule making for all mutual funds, not just money market funds, which was buried in a footnote within an almost 900 page release,” the Commissioner noted.
“Our enforcement program could also benefit from a look through the lens of fairness,” Commissioner Piwowar stated. Recently, the staff indicated that they will recommend instituting more enforcement matters as administrative proceedings, including insider trading cases. “Announcement of this plan to increase the use of administrative proceedings in insider trading cases followed the Commission’s loss in two insider trading cases in federal district courts. Regardless of whether these circumstances are linked, this change has the appearance of the Commission looking to improve its chances of success by moving cases to its in-house administrative system,” according to the Commissioner. To avoid the perception that the Commission is taking its tougher cases to in-house judges “the Commission should set out and implement guidelines for deterring which cases are brought in administrative proceedings and which in federal courts.”
The imposition of corporate penalties and the issuance of waivers are two additional areas which would benefit from the consistent application of public guidelines. While the Commission offered guidance on corporate penalties in 2006, recent remarks by the SEC Chair raises doubts about those guidelines which are often ignored in staff recommendations. Likewise, Commissioners have been ignoring the established staff guidelines regarding waivers. While staff guidance need not be followed, where there are established practices they should be followed.
Orderly means that the Commission must at times prioritize its agenda in areas such as rule making, enforcement and inspections. To function efficiently the agency should prioritize its rule makings. In the area of enforcement it means that the “broken windows” approach does not work. By making regulatory compliance its most important objective the approach unnecessarily delimits important economic activity. Rather, enforcement efforts should be “closely aligned with the priorities developed by out policy-making division,” according to the Commissioner. In contrast OCIE has made significant strides in developing priorities.
Finally, it is critical that the Commission become more efficient. The increased utilization of technology is one way to help achieve this goal. Another is by “[e]ngaging with academics, attorneys, and others from the securities industry who work outside the SEC [and who] could greatly enhance our ability and effectiveness in identifying changes to improve our regulatory regime.”
Commissioner Daniel M. Gallagher centered his remarks on efforts to create a uniform fiduciary standard to which he is opposed. Recounting the history of these efforts, he noted that in 2010 the Department of Labor issued a proposal for such a standard. The proposal, which would have radically changed the law, according to Commissioner Gallagher, would have broadly defined the term “fiduciary” under ERISA to include any person who provided investment advise to plans for compensation. Following largely negative comments the proposal was withdrawn. In reformulating its proposal (which was recently issued) it did not consult with the SEC Commissioners.
In 2011 the SEC staff issued a study under Section 913 of Dodd-Frank calling for a uniform fiduciary standard for investment advisers and broker- dealers who provide investment advice regarding securities to retail customers. Two Commissioners opposed the proposals, noting that it did not adequately identify the issues to be addressed through additional regulation.
Recently a White House paper called for a similar standard. It was built on three basic principles. First, consumer and investor protections are inadequate. This point is not supported by any analysis, according to Commissioner Gallagher.
Second, the current regulatory environment “creates perverse incentives” that cost savers billions of dollars. At the same time, according to Commissioner Gallagher, there are SEC and SRO rules which address these issues. Finally, the White House memo states that academic research has established that advisors often act “opportunistically to the detriment of their clients” because of conflicts. Again, the point ignores current regulation. Accordingly, the White House position paper on this point is seriously flawed, the Commissioner concluded.
At the same time the extent of the SEC’s investment adviser examinations is “unacceptably narrow” which impacts SEC policy making in this area. Last year only 10% of the advisers were examined. This low rate of examinations can hinder the SEC’s work since the “purpose of an active and well-resourced examination program is an informed policymaking function, not a large, attention-grabbing number of enforcement referrals.” This limited focus also impacts the enforcement actions brought by the agency.
In the end fiduciary is supposed to mean that the adviser acts in the best interest of its client. It does not mean “that all models where financial professionals are not fiduciaries are flawed,” the Commissioner noted.
February 24, 2015
The SEC Speaks conference has traditionally been a forum in which the agency reviewed significant recent undertakings and indicated its future direction. This year was no different. Four of the five Commissioners addressed conference participants, discussing recent significant undertakings and sketching the future direction of the SEC. This article reviews the comments of Chair Mary Jo White and Commissioner Stein. An article tomorrow will review the remarks of Commissioners Piwowar and Gallagher.
Chair Mary Jo White: Ms. White reviewed recent significant rule making initiatives by the agency before turning to a discussion of the enforcement efforts last year and future undertakings. Last year the Commission focused on three key rule making initiatives tied to the risks exposed by the financial crisis. First, the SEC reformed money market funds. New rules were promulgated regarding institutional prime money markets funds. Those funds will be required to maintain a floating net asset value, for the first time. At the same time non-government money market funds will have new tools to address runs on the fund while all money market funds will be subject to enhanced diversification, disclosure, reporting and stress testing requirements.
Second, the agency moved forward with its mandate under Title VII of Dodd-Frank regarding the swaps market. The SEC has now proposed all of the required rules. Last June it adopted the threshold rules that create the foundation for the regulatory regime for these products. Early this year the SEC adopted two sets of rules which will add transparency to these markets.
Finally, last year the Commission adopted what Chair White called a “strong, comprehensive package of reforms for the regulation and oversight of credit rating agencies, implementing over a dozen rulemaking requirements under the Dodd-Frank Act. The SEC also proposed additional rules to enhance oversight of clearing agencies and requiring companies to disclose their hedging policies.
Enforcement set records last year, bringing 755 actions and obtaining over $4.1 billion in monetary relief, accord to Ms. White. She then reviewed a series of “first of a kind” cases, summarizing the SEC’s earlier press release on enforcement. OCIE complemented these efforts by conducting over 1,850 examinations, an increase of 15% compared to the prior year.
For 2015 Ms. White highlighted three core initiatives. First, the “staff is developing recommendations to enhance the transparency of alternative trading system operations, expand investor understanding of broker routing decisions, address the regulatory status of active proprietary traders, and mitigate market stability concerns through a targeted anti-disruptive trading rule.” Those efforts will be aided by the formation of the new Market Structure Advisory Committee.
Second, the staff is developing three sets of initial recommendations to address the increasing complexity of portfolio composition and the operations of the asset management industry. Those initiatives center on improving data reporting, requiring funds to have controls in place to more effectively identify and manage risks and on planning for market stress events.
Finally, in 2015 the Commission will focus on capital formation for smaller issuers. The final two major mandates of the JOBS Act will be a key focus as well as the pilot program to widen tick sizes for the stocks of smaller companies.
Commissioner Kara Stein delivered remarks which centered on three key topics. First, the Commissioner noted that the agency should “be reimagining disclosure and [the use of] data to keep pace with the digitized and data-centric market.” Now is the time to consider a “fundamental shift in disclosure.” Commissioner Stein mentioned two potential initiatives. One would involve updating EDGAR. A second would focus on making data “available more quickly and in a format that is more usable . . .” In this regard data could be made available so that investors could “click” their way through to “deeper and more extensive information.”
Ms. Stein then turned to the question of over complexity in financial products. Once of the lessons of the great crash of 1929 was the pyramiding of leverage and complexity that ultimately played a role in the crash of the market. That lesson was reiterated in the last financial crisis when innovation created very complex financial instruments that ultimately imploded. It is imperative that everyone learn the lesson that innovation in financial products can lead to a level of over-complexity.
Finally, turning to enforcement, Commissioner Stein focused on what she called “bad actor bars,” a topic which is becoming of increasing concern. Here Ms. Stein began by stating “Let me be clear, bad actor bars, including partial bars or conditional waivers, are not intended to be used as ‘punishment.’” The critical question is whether these tools are being properly and effectively applied.
The building blocks for the application of these provisions are recidivism and deterrence. This begins with tone at the top of the organization: “The degree to which those at the top knew or should have known about a violation or a failed culture of compliance is an important factor in analyzing whether an automatic bad actor bar should occur. I have been urging the Commission to adopt and use this factor in the context of evaluating these bars. And if a firm is so sprawling and large that the top simply cannot manage it at all isn’t that a problem in and of itself . . .” Commissioner Stein noted.
The critical question in applying these provisions is not whether the reason for the automatic disqualification is “unrelated” to the waiver. Rather, “If you manipulate LIBOR, enable offshore tax evasion, or launder drug money, should we wait for you to defraud a pension fund before barring you from raising money outside of strict Commission oversight?” the Commissioner asked. The point here should be to continue developing a consistent and transparent process for the application of bad actor bars.
Tomorrow: Commissioners Piwowar and Gallagher
February 22, 2015
Waivers from the automatic disqualifications of the “bad boy” provisions which can come into play following the resolution of a Commission enforcement action is a topic of increasing concern. Consider the recent decision regarding Oppenheimer for example. There the Commission agreed to waivers based on certain conditions for a firm with a long history of violations and with what some view as a huge tone at the top problem over the dissent of two Commissioners.
Now Commissioner Gallagher is proposing a new approach to the use of these provisions. Under his approach the SEC consider the issue in conjunction with the resolution of the underlying enforcement action, not as a separate matter which is the current practice.
The bad boy provisions
The bad boy provisions generally refers to a collection of various provisions in the securities laws which are triggered by the resolution of a Commission enforcement action. Typically those provisions preclude the settling party from relying on exemptions that otherwise would be available to them. The first was created in the 1930s along with the Regulation A exemption. It contains an automatic disqualification for anyone subject to an injunction. In 1940 the Investment Company Act added Section 9(a). It contains an automatic disqualification from acting as an adviser to a registered investment company upon entry of an injunction.
In 1982 a Reg. A type provision was written into Regulation D. Rule 405, adopted in 2005, specified that issuers who have violated the anti-fraud provisions of the Federal securities laws are not eligible to be considered as well-known seasoned issuers. Similarly, Section 926 of Dodd-Frank directed the SEC to issue Rule 506(d), the provision of Regulation D, which precludes felons and other bad actors who have violated Federal and State securities laws from continuing to use the Rule 506 private placement process.
Purpose of the provisions
A critical question regarding these provisions, according to Commissioner Gallagher, is their purpose. Some may consider them backward looking sanctions for misconduct. Others may argue that they were meant to be forward looking and prophylactic. Since there is little legislative history for any of the provisions, guidance is sparse.
At the same time, a “common thread runs through the legislative and SEC records underlying each of these disqualification provisions: Congress and the SEC may be willing to allow for exemptions from otherwise applicable restrictions or burdens, but only to those persons who are unlikely to abuse that relief through fraudulent or other improper conduct. They recognize that the disqualifications were intentionally over-broad and thus necessitated an exceptive process to be employed when the facts and circumstances warranted a less heavy-handed approach . . .” according to the Commissioner.
The SEC’s historical approach followed this path. Traditionally, the staff approached disqualifications and waivers against a backdrop of reducing a repetition of wrongful conduct. Waiver requests were handled by the policy division staff on the merits pursuant to delegated authority separate and apart from the underlying enforcement action. At the same time the Commission remained free to take up any action it deemed appropriate.
Recently, according to the Commissioner, some have come to view these provisions as sanction enhancement. The SEC should resist this approach and not “conflate” disqualifications and enforcement sanctions he argues. This process is “exacerbated by the informal, non-Commission-approved, practice recently followed by the Enforcement Division of not allowing respondents to condition settlements on the granting of waivers. This makes no sense to me. If a disqualification is now a sanction, then the waivers must be part of the settlement process .. .” Commissioner Gallagher noted. This is because “I cannot fulfill my duty as a Commissioner to cast a vote in favor of a recommendation without the ability to accurately assess what punishments will be meted out . . . and whether those punishments are just given the nature of the violation . . .” the Commissioner stated.
The path forward
The “ideal” solution to the current cross-roads at which the Commission finds itself would be to return to the historical practice, according to Commissioner Gallagher. At this point, however, that does not appear possible. Accordingly, Commissioner Gallagher is calling for the SEC to amend its practice and consider the question of waivers in conjunction with the underlying enforcement action. If the Commission is unable to adopt this approach, then Congress should step in and mandate it.
The question of remedies is a critical question for the agency. Historically its equitable remedies served the purposes on which the federal securities laws are based. The injunction, equitable relief, and fashioning provisions which at once reformed a violating issuer and prevented a reoccurrence in the future were the approach of choice. Reforming corporate governance for the good of the shareholders was key.
The Remedies Act and the advent of monetary penalties changed the focus. Regardless of its intent, today large dollar penalties that generate headlines are the name of the game. More dollars, more headlines. Whether those headlines serve their preventative purpose is debatable. Nonetheless, they are a key part of the omnipresent, broken windows approach of the agency today.
Commissioner Gallagher’s comments on the use of the bad boy provisions only serves to highlight this trend. Provisions he describes as intentionally over broad and a blunt instrument are being administered as additional punishment after the settlement is done. That turns settlement into a game of roulette – maybe there is more punishment and maybe not. If fundamental fairness is to be the hallmark of an effective enforcement program, it is surely lacking from this approach.
What all of this points out, however, is not just that the approach to, and the application of, the bad boy provisions requires reconsideration, but all enforcement remedies. It is time for the agency to reconsider the purpose of its enforcement remedies as well as their application in an open and transparent way that allows for discussion and comment before any steps are taken. Initiating this process, and doing it in this manner, could do much to restore the image which has in recent years eluded the agency – that of a tough but fair enforcement authority.
February 19, 2015
The Commission recently filed an amicus brief defending its Dodd-Frank whistleblower rules. Those rules specify that the anti-retaliation provisions of those amendments to the Exchange Act protect those who chose not to report to the Commission but only internally. Yet the definition of whistleblower under Dodd-Frank is limited to those who report to the SEC.
Commissioner Gallagher continued to raise questions regarding disqualifications in his recent remarks. The Commissioner’s comments echo his recent dissent in the Oppenheimer matter.
This week SEC also filed an insider trading action, a misappropriation case, an action based on bid rigging, and a proceeding alleging fraudulent registration by an investment adviser. In addition, a case centered on a pyramid scheme and an investment fraud action brought in conjunction with the NYAG were filed.
Municipal securities markets: Commissioner Luis A. Aguilar, issued a Statement on Making the Municipal Securities Market More Transparent, Liquid and Fair (Bev. 13, 2015)(here).
Disqualifications: Commissioner Daniel M. Gallagher addressed the 37th Annual Conference on Securities Regulation and Business Law, delivering remarks titled Why is the SEC Wavering on Waivers? (Feb. 13, 2015). The Commissioner’s remarks follow his dissent on the question in the Oppenheimer case (here).
Whistleblowers: Berman v. Neo@Ogivy LCC, No. 14-4626 (2nd Cir. Brief filed Feb. 6, 2015) is an action in which the SEC filed an amicus brief addressing the scope of the protections for whistleblowers provided by the anti-retaliation provisions added to the Exchange Act by Dodd- Frank. Specifically, the issue in the brief centers on the question of whether a Commission rule, which provides that the anti-retaliatory protections apply to whistleblowers who report internally but not to the SEC, is entitled to Chevron deference. While the Commission argues in support of its rule, the Fifth Circuit has taken a contrary position (here).
Canadian securities class actions
Filings for new Canadian securities class actions have been essentially flat over the last three years, according to a recent report by NERA Economic consulting (here). Last year there were 11 securities class actions filed in Canada, the same as in the prior year and one more than in 2010. The largest number of these cases for a single year since 1997 was 15 in 2011 (here).
SEC Enforcement – Filed and Settled Actions
Statistics: During this period the SEC filed 4 civil injunctive actions and 2 administrative proceedings, excluding 12j and tag-along-actions.
Insider trading: SEC v. Zeringue, Civil Action No. 3:15-cv-00405 (W.D. La. Filed Feb. 19, 2015) is an action which names as defendants Scott Zeringue and Jessie Roberts. Mr. Zeringue is the vice president of construction operations at Shaw Group, Inc., an energy construction company. Mr. Roberts is his brother-in-law. The action centers on the acquisition of Shaw by Chicago Bridge & Iron on February 13, 2013. Prior to that time Mr. Zeringue learned of the then pending deal through his employment. He purchased 125 shares of Shaw, told his brother-in-law about the deal and asked him to purchase additional shares for him. Mr. Roberts made purchases, and tipped Friend A and a relative of that person. Both traded. Overall Mr. Roberts had trading profits of $765,000 while the other traders profits totaled $154,000. Mr. Roberts paid his brother-in-law $30,000 for the tip. The action alleges violations of Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 232022 (Feb. 19, 2015).
Bid-rigging: In the Matter of VCAP Securities, LLC, Adm. Proc. File No. 3-16389 (Feb. 19, 2015) is a proceeding which names as Respondents the firm, a registered broker dealer, and Brett Graham, its CEO. Vertical Capital LLC is an affiliated investment adviser which managed funds. The firm served as a liquidation agent for certain CDOs. As part of its undertakings and representations to the Trustee, the firm was not supposed to bid. To circumvent that restriction Respondents arranged for others to bid in the auctions on behalf of funds managed by Vertical. In making those binds Respondents were able to use confidential information obtained from the bidding process. The Order alleges violations of Exchange Act Section 10(b). Both Respondents settled, consenting to the entry of cease and desist orders based on the Section cited. The firm was censured. In addition, the firm paid $1,046,555 in disgorgement plus prejudgment interest while Mr. Graham paid $118,280 in disgorgement plus prejudgment interest. Mr. Graham will also pay a penalty of $200,000 and was barred from the securities business and from participating in any penny stock offering with a right to apply for re-entry after three years. The firm will not pay a penalty based on financial condition.
Misappropriation: SEC v. Cohen, Civil Action No. 15-cv-0129 (D. N.J. Filed Feb. 19, 2015) is an action which names as defendants Michael Cohen and Proteonomix, Inc., a biotech company. Mr. Cohen is the CEO. From 2008 through 1012 Mr. Cohen diverted about $600,000 of corporate funds to his personal use by channeling company shares into entities supposedly controlled by his father-in-law. In fact Mr. Cohen controlled the bank and brokerage accounts for the entities and ultimately sold the for his benefit. The transfers were falsely recorded on the books and records of the company and were transferred in unregistered transactions. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). Each defendant settled, consenting to the entry of permanent injunctions based on the Sections cited in the complaint. Mr. Cohen also agreed to the entry of office and director and penny stock bars. Monetary relief will be determined later. A parallel criminal action was filed. See Lit. Rel. No 23301 (Feb. 19, 2015).
Fraudulent registration: In the Matter of Logical Wealth Management, Inc., Adm. Proc. File No. 3-16390 (Feb 19, 2015) is a proceeding with names as Respondents the registered investment adviser and Daniel Goper, its President. From 2006 through 2011 the firm improperly registered with the Commission as an advise by inflating its assets. In June 2012 following Dodd-Frank the firm falsely represented that its principle office was in the State of Wyoming, the only state with no legislation for the registration of advisers. Under Dodd-Frank this permitted the firm to register with the SEC. The Order alleges violations of Advisers Act Sections 203A, 204(a), 204A, 206(4) and 207. The Respondents consented to the entry of cease and desist orders based on the Sections cited in the Order. In addition, the firm’s registration was revoked and Mr. Goper will pay a $25,000 civil penalty.
Pyramid scheme: SEC v. Johnson, Civil Action No. 1:15-cv-00299 (D. Colo. Filed February 12, 2015) is an action which names as defendants, Kristine Johnson, Troy Barnes and Work With Troy Barnes, Inc. Ms. Johnson and Mr. Barns are co-founders of the company. Since April 2014 the defendants have raised over $3.8 million from investors through videos and other promotions of the company. Investors were told that the firm generates extraordinary returns through a “triple algorithm” that the two individual defendants developed. This creates a limitless stream of life time returns. The firm is actually a Ponzi and pyramid scheme, according to the complaint. To date the individual defendants have misappropriated at least $200,000. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending.
Investment fund fraud: SEC v. Malik, Civil Action No. 15-1025 (S.D.N.Y. Filed February 13, 2015). Defendant Mozzam Malik, who registered with FINRA as a stock broker trainee in 2007, was formerly a waiter, NYPD traffic agent and security guard who attended high school in Pakistan. His company, defendant American Bridge Investment Group, LLC, has not had a physical office since 2011. Since at least May 2011 Mr. Malik has solicited investors for his hedge fund. Many of the solicitations were made by unpaid staff who cold called potential investors. Potential investors were promised a partnership interest in Mr. Malik’s hedge funds. Those funds, investors were told, held a multi-million dollar portfolio of investments in various high profile IPOs and secured bond transactions. At times an offering memoranda was used which claimed the fund had a valuation of over $100 million. At other times e-mail was used to solicit investors. The promised returns were represented as being very high. The profits came from a proprietary, quantitative approach to investing combined with sophisticated risk-control techniques. All of this was supposedly supervised by Mr. Malik who, according to the website, had over a decade of Wall Street experience and had lead teams which managed over $5 billion. The claims were false. While about $840,774 was raised from investors, the fund never held much more than $90,000. The balance of the investor funds were misappropriated by Mr. Malik, according to the court papers. Ms. Ebert, an IR person who responded in e-mails which included her photo to investor complaints, does not exist, although the photograph was of a real person. The lady in the photograph had no knowledge of Mr. Malik or his operation. The Commission’s complaint alleges violations of Securities Act Sections 5(a) and 5(c) and 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), (2) and (4). See Lit. Rel. No. 23197 (February 13, 2015). The case is pending. The NY AG brought a parallel criminal action.
Investment fund fraud: U.S. v. Tagliaferri, Case No.1:13-cr-0115 (S.D.N.Y.) is an action in which the president of TAG Virgin Islands, James Tagliaferri, was sentenced to six years in prison for defrauding his investment advisory clients. Specifically, he was alleged to have taken undisclosed compensation in exchange for recommendations to clients, diverted client funds to his own purposes and caused fictitious securities into client accounts. He was convicted following a nearly five week jury trial (here).
Stop order: The Australian Securities and Investment Commission issued a stop order against Bitcoin Group Ltd. from publishing any statements concerning its intention to make a public offering of its shares until the filing of a prospectus. The firm was using social media to announce its intentions, targeting the Chinese community. The announcements were made prior to the time the firm registered as an Australian company and before any disclosure document was filed.