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Prepared by:

Thomas O. Gorman,
Dorsey and Whitney LLP
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Gorman.tom@Dorsey.com

 
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    Compliance, Remediation and Effective SEC Enforcement

    October 21, 2013

    Compliance is a critical function for a public company. While it can be viewed as simply a “cost of doing business” perhaps it is better considered as a critical business component, helping create a market place brand of a fair and ethical dealing reflecting its culture. That image, of course, aids success in the market place. It also aids the resolution of regulatory problems.

    Far to often the role of compliance is lost in the discussion of multi-billion dollar fines, admissions of fact and wrong doing and sanctions which punish, all of which garner huge headlines. When those headlines fade, however, they do little to ensure that the company will be a fair and ethical market place participant in the future. Yet that should be a critical goal of SEC enforcement whose mission is not just to discover and halt wrongful conduct but to prevent its replication in the future, thereby protecting the investing public and the markets.

    Recently, SEC Associate Director, Enforcement, Stephen Cohen, addressed the question of compliance and its critical role in the enforcement process. Stephen L. Cohen, Remarks to SCCE Annual Conference, Washington, D.C. (Oct. 7, 2013)(here). While compliance has frequently been addressed by the Commission and other regulators and others in the FCPA area, it is not the topic of the day in this era of “get tough” enforcement.

    The remarks

    Compliance is critical and key to SEC enforcement Mr. Cohen began. “But among the most concerning risk I see is companies that do not take compliance seriously until misconduct comes to light . . .” he noted. Compliance is a critical consideration by the staff when evaluating the evidence from an investigation and determining how to proceed. Yet “I am surprised how infrequently companies try to persuade us at the front end of an investigation that they have a robust compliance culture and record of ethical conduct . . .” Mr. Cohen stated (emphasis original). This is particularly true since the agency gives credit for compliance efforts in the charging process. Compliance professionals should thus “tell your management that they will get much more credit from regulators by demonstrating that misconduct is an outlier in a highly ethical and compliance-driven culture rather than a remedial step after investors have suffered losses.”

    If the issue is one of formal guidance, companies should look to the recently published FCPA Resource Guide regarding compliance programs. The guidance there, while stated in the context of anti-corruption compliance, is “applicable to detecting and preventing securities law violations generally,” according to Mr. Cohen. Indeed, the Guide makes it “crystal clear” that the Commission will consider the compliance program of a company as a factor in any charging decision and determining the appropriate resolution for the inquiry. Recent examples are the Morgan Stanley/Peterson declination and the non-prosecution agreement which resolved the Ralph Loren inquiry, both FCPA cases.

    The importance of compliance to the Commission is demonstrated through what Mr. Cohen called the “Compliance initiative.” This initiative, undertaken with the National Exam Program and in conjunction with the Asset Management Unit of enforcement, focuses on identifying “and brining cases against registered investment advisers who lack effective compliance programs and procedures . . . To date, the Commission has brought six actions arising out of this initiative . . .” according to Mr. Cohen. The National Exam Program also meets with firms to assess “the culture of compliance and ethics in the organization.”

    Mr. Cohen then focused his remarks by identifying first warning signs of a potential issue and the hallmarks of an effective compliance program. The warning signs include:

    Pushing the envelope which was defined as engaging in risk taking in the area of legal and ethical obligations;

    Technical compliance which applies to those who take an overly technical approach to ethics and compliance;

    Be skeptical to explanations that “don’t add up” regardless of their sources; and

    Lack of empowerment that is, an organization that limits the access of its compliance personnel to senior company leadership.

    Building on these points Mr. Cohen identified five critical elements for an effective compliance program:

    Governance which focuses on tone at the top and to whom the senior compliance personnel report; an evolving trend centers on adding compliance expertise to the audit committee;

    Culture and values flow from good governance and an organization in which there is interaction with leadership across the organization;

    Incentives and rewards can be used to infuse ethical values into the firm’s culture;

    Escalation, investigation and discipline is critical and can foster the kind of culture where whistleblowers report internally first rather than later; and

    Continual self-evaluation and improvement which means that the organization keeps pace with an evolving market place and best practices.

    The proper application of these principles will create a “strong compliance and ethics program [which] not only provides direct economic benefits to your company but will also allow you to reap significant credit should you ever deal with us or our law enforcement colleagues” Mr. Cohen concluded.

    Comment

    There is no doubt that effective compliance can pay dividends to the company as it competes in the market place and in resolving regulatory and law enforcement investigations. Nevertheless, today the critical component of every Commission and enforcement resolution seems to be the total amount of money paid, the size of the fine, the amount of the disgorgement and the penalties imposed. Indeed, at times the only questions seem to be “how much did they pay” and “did anyone go to jail.” While punishment may equal deterrence in some instances, the focus of SEC enforcement should be more than just stopping violations and retribution.

    Mr. Cohen was clearly correct when he suggested that in many ways compliance and enforcement are partners. Compliance seeks to prevent wrongful conduct and, when it does, the program is successful. Alternatively, if wrongful conduct does occur it can serve as a defense. Enforcement also seeks to prevent wrongful conduct, but from reoccurring and again injuring investors and shareholders. When it prevents a future replication of the conduct, SEC enforcement goes beyond generating yesterday’s headline and becomes effective. This means that corporations and the Commission need to emphasize compliance.

    SEC Brings Another Market Crisis CDO Case

    October 20, 2013

    The market crisis ended but enforcement actions stemming from it have not. Battered financial giant JPMorgan, fresh from its settlement with the CFTC relating to the London Whale episode, reportedly is about to settle for its role in the mortgage debacles which many believe were at the center of the crisis. The price will be a record $13 billion. The settlement will be with the Department of Justice, not the SEC, for civil liability. The criminal investigations will continue, leaving the bank at risk.

    The SEC also brought another market crisis related case at the close of last week. An administrative proceeding was brought against registered investment adviser and collateral manager Harding Advisory LLC and its principal, Wing Chau. In the Matter of Harding Advisory LLC, Adm. Proc. File No. 3-15574 (October 18, 2013).

    The allegations in Harding are familiar, echoing those in Goldman Sachs, Citigroup and other market crisis cases. In the Spring of 2006 hedge fund manager Magnetar Capital LLC approached Merrill Lynch to arrange a series of CDO transactions. An arrangement was discussed under which Magnetar and Merrill would pick a mutually agreeable collateral manager that would work with the hedge fund manager who would play a significant role in structuring the composition of the portfolio. Magnetar would retain the equity, or lowest class, and Merrill would distribute the debt. Magnetar’s strategy, in part, was to hedge the positions in the CDO’s, meaning its interests were not aligned with the success of the entity.

    Subsequently, Magetar and Merrill agreed on the selection of Harding as collateral manager for what would be known as Octans 1. Mr Cheu understood that Magnetar was interested in investing as the equity buyer in a series of potential CDO transactions. He also knew about the hedging strategy of Magetar.

    Merrill, Harding and Magnetar then entered into the warehouse agreement which would govern the acquisition of the collateral for Octans 1. Under the agreement Magnetar would receive a percentage of the returns on the assets while they were carried. The agreement also gave the hedge fund manager the right to: 1) veto collateral selected by Harding; 2) agree with Merrill and Harding on the price paid; 3) and veto a designation by Merrill of any warehoused collateral as “ineligible.”

    Harding also executed a Collateral Management Agreement in connection with the deal. It specified in part that Harding would perform its obligations with reasonable care and would use a “degree of skill and attention no less than that which [it] would exercise with respect to comparable assets that it manages for itself . . .” Nevertheless, as the collateral was selected, significant portions were disfavored by Harding. The manager understood, however, that it met the requirements of Magnetar.

    The offering circular for Octans I reiterated the standard of care from the Collateral Management Agreement. The “pitchbook” used to solicit investors, drafted by Harding, described the firm’s approach and credit processes. Neither the offering circular nor the pitchbook mention Magnetar or its role and interests.

    The Order alleges violations of Securities Act Section 17(a) and Advisers Act Sections 206(1) and 206(2). The proceeding will be set for hearing.

    This Week in Securities Litigation (Week ending October 18, 2013)

    October 17, 2013

    The SEC lost another major case this week when a jury found against the agency and in favor of Mark Cuban on insider trading claims after deliberating only a few hours. The Commission also filed two settled cases this week, one against Knight Capital arising out of its recent computer issues which caused a frenzy of trading for a brief period and a second against a Ponzi scheme operator.

    The CFTC settled charges with JPMorgan arising out of the London Whale debacle. The settlement includes admissions of fact, remedial undertakings, a cease and desist order and the payment of a $100 million fine. The settlement is the first time the agency has invoked its new antifraud authority granted under Dodd-Frank. It is also the first time the agency has obtained admissions in connection with a settlement.

    SEC

    Remarks Mary Jo White, SEC Chair, delivered remarks tilted “The Path Forward on Disclosure Policy” to the National Association of Corporate Directors (October 15, 2013). The remarks focused on the purpose of disclosure and possible revisions to policy (here).

    Remarks: Chair Mary Jo White’s addressed the Securities Enforcement Forum, Washington, D.C. (Oct. 9, 2013)(here). Her remarks focused on enforcement policy.

    Remarks: Stephen Cohen, Associate Director, SEC Division of Enforcement, delivered remarks to the SCCE Annual Conference, Washington, D.C. (Oct. 7, 2013) which focused on compliance issues (here).

    CFTC

    Remarks: Commissioner Scot D. O’Malia addressed the Edison Electric Institute CFTC Compliance Forum, Washington, D.C. (Oct. 17, 2013). His remarks included comments on the rule making process of the agency, futurization, and the readiness of the Commission to oversee the implementation of Dodd-Frank (here).

    SEC Enforcement – litigated cases

    Insider trading: SEC v. Cuban, Civil Action No. 3-08-CV-2050 (N.D. Tx.) is the insider trading case against Mark Cuban, the owner of the Dallas Mavericks. The jury returned a verdict yesterday against the SEC and in favor of Mr. Cuban. The SEC’s complaint claimed that Mr. Cuban engaged in fraudulent, insider trading when he sold a large stake in Mamma.com and avoided what later would have been a loss of over $700,000. The sale followed phone calls with Mamma officials in which Mr. Cuban, as the firm’s largest shareholder, was told about a coming PIPE offering. Those officials claimed that Mr. Cuban was told the information was confidential. There were remarks by Mr. Cuban, according to the complaint, which suggested he understood he could not trade. The district court dismissed the complaint and the SEC declined to amend. The Fifth Circuit Court of appeals reversed. The jury, however, found for Mr. Cuban.

    SEC Enforcement

    Weekly statistics: This week the Commission filed or announced the filing of 2 civil injunctive actions and 1 administrative proceeding (excluding follow-on actions and 12(j) proceedings).

    Investment fund fraud: SEC v. CKB Holdings Ltd., Civil Action No. 13-5584 (E.D.N.Y. Filed under seal October 9, 2013) is an action against sixteen defendants including Rayla Melchor Santos, Hung Wai Shern, Rui Ling Leung and a group of entities called the CKB entities. The complaint alleges that since mid-2011 defendants have raised over $20 million from U.S. investors and millions more from those in Canada, Taiwan, Hong Kong and other countries. Investors were solicited to invest in the CKB entities which supposedly marketed children’s educational courses. Riskless profits were to come from Profit Reward Points granted to investors which increased in value or paid dividends. Additional profits were to come from an IPO and listing on the Hong Kong stock exchange. In fact the representations were false. The companies engaged in little business and no steps were taken toward an IPO. The complaint alleges violations of Securities Act Sections 5(a), 5(c), and 17(a)(1) and (3) and Exchange Act Sections 10(b) and 15(a)(1). A freeze order was entered by the Court. See Lit. Rel. No. 22846 (Oct. 17, 2013).

    Financial statement fraud: SEC v. JBI, Inc., Civil Action No. 1:12-cv-10012 (D.Mass.) is a previously filed action against the company, John Bordynuik and Ronald Baldwin, Jr. The complaint alleged that during two reporting periods in 2009 that the company overstated the value of certain assets by almost 1,000%. The company and Mr. Bordynuik, the CEO, previously settled. This week the Court entered a final judgment by consent against Mr. Baldwin, the former CFO. That judgment permanently enjoins him from engaging in future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). He was also barred from serving as an officer or director of a public company for five years and directed to pay a fine of $25,000. See Lit. Rel. No. 22847 (Oct. 17, 2013).

    Market access: In the Matter of Knight Capital Americas LLC, Adm. Proc. File No. 3-15570 (October 16, 2013) is a settled administrative proceeding against registered broker dealer Knight Capital. The Order centers on the events of August 1, 2012 when a computer error that occurred in connection with the execution of 212 small retail orders resulted in 4 million executions in 154 stocks for more than 397 million shares in 45 minutes. Overall Knight purchased $3.5 billion long positions in 80 stocks and $3.15 billion short positions in 74 stocks. The Order finds that Knight violated the market access Rule adopted in 2010 by failing to reasonably maintain effective systems. Overall the firm suffered $460 million in losses. This is the first proceeding based on that Rule. To resolve the proceeding Knight agreed to adopt a series of remedial undertakings which included retaining one or more independent consultants who will prepare a report that will be submitted to the staff regarding the pertinent procedures with recommendations that will be adopted. The firm also consented to the entry of a cease and desist order based on Exchange Act Section 15(c)(3), Rule 15c3-5 and Rules 200(g) and 203(H) of Regulation SHO and a censure. The firm will pay a $12 million penalty.

    False reports: SEC v. Madoff, Civil Action No. 12-cv-5100 (S.D.N.Y.) is a previously filed action against Peter Madoff, brother of the Ponzi king, alleging that he made “stacks” of false documents in support of his brother’s fraud, including account reports and filings. The Court entered a default judgment against Mr. Madoff and a permanent injunction prohibiting future violations of Exchange Act Sections 10(b), 15(b)(1), 15(c) and 17(a) and Advisers Act Sections 204, 206(1), 206(2), 206(4) and 207. No monetary relief was entered in view of Mr. Madoff’s criminal conviction and the $143 billion restitution order entered in that case. See also Lit. Rel. No. 22845 (Oct. 15, 2013).

    Investment fund fraud: SEC v. Enea, Civil Action No. 2:13-cv-01151 (E.D. Wisc. Filed October 10, 2013) is an action against Michael Enea alleging that he operated a Ponzi scheme from about July 2006 to May 2013 which raised about $2.1 million from 18 investors. Those investors were falsely told that their money would be invested in a “credit card portfolio,” supposedly proceeds from a group of retail merchants who pay fees to a third party processor when there is a charge. Investors were to receive a stream of monthly payments. In fact most of the money was used to repay other investors while portions were taken by Mr. Enea for personal use. To resolve the matter Mr. Enea consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b) and 15(a). He is also required to pay disgorgement of $763,803 and prejudgment interest. See Lit. Rel. No. 22842 (October 11, 2013).

    CFTC enforcement

    Trading: In the Matter of JPMorgan Chase Bank, N.A, (Filed October 16, 2013) is an administrative proceeding naming the bank as a Respondent. It centers on the “London Whale” trading episode. Over a four year period beginning in 2007 the Chief Investment Office of JPMorgan built a large portfolio of CDX, a particular type of credit default swap, through its London desk. While the portfolio was typically profitable, in early January 2012 when it held billions of dollars in positions the market was moving against it. On February 29 the traders “recklessly employed an aggressive trading strategy in one particular CDX. The CIO sold net more than $7 billion of the CDX, with about $4.6 billion of the sales taking place in the last three hours of the market day. In the prior two days the unit had sold over $3 billion of the index. Overall, the transactions by the CIO in the three days amounted to about one-third of the volume traded in the month of February. As the sales took place the market price declined which benefited the portfolio. The controls over the CIO did not prevent it from accumulating these huge positions or taking steps to conceal the losses. The ultimate loss from the trading was over $6 billion. The Order alleges violations of Section 6(c)(1) of the CEA which was added under Dodd-Frank. Based on Exchange Act Section 10(b), it prohibits in connection with any swap . . . “intentionally or recklessly” employing any device or scheme or artifice to defraud. JPMorgan resolved the proceeding by: 1) entering into a series of undertakings; 2) admitting to the fact sections cited in the Order but not the conclusions of violation; 3) consenting to the entry of a cease and desist order based on Section 6(c)(1) and the pertinent rules; and 4) paying a fine of $100 million. In a footnote the agency stated it does not have the resources to prosecute the individuals involved. This is the first enforcement action in which the trading Commission obtained admissions.

    Hong Kong

    MOU: The Securities and Futures Commission entered into a Memorandum of Understanding with the Financial Regulatory Commission of Mongolia. The MOU pertains to cross boarder matters and enforcement.

    SEC v. Cuban: Another Major Loss For the SEC

    October 16, 2013

    Credibility. It is all about credibility. Building an effective enforcement program is all about credibility. For the SEC’s enforcement program credibility begins with winning in the courtroom. If the program is going to flourish it must be able to win at trial. Courtroom wins permits the agency to tell would be defendants in pre-filing settlement negotiations that the best offer is on the table, it is fair, and if not accepted the case will be successfully litigated. Courtroom wins in major cases make the would be defendant think twice before spurning that offer in the hope of escaping through trial.

    Being willing to take the case to trial is important but not enough. When faced with going to trial those who do not have the resources to litigate with a government agency may make a business decision to settle; others may simply plod through the trial and lose. Those with the resources, however, will not be compelled to settle when faced with the prospect of trial if the agency’s claim is not backed by courtroom wins that create credibility.

    SEC v. Cuban, Civil Action No. 3-08-CV-2050 (N.D. Tx.) is the high stakes insider trading case against the owner of the Dallas Mavericks. The jury returned a verdict yesterday against the SEC and in favor of Mr. Cuban. This is another loss in another major courtroom battle for the Commission.

    To be sure, the case was challenging from the beginning. The SEC’s complaint claimed that Mr. Cuban engaged in fraudulent, insider trading when he sold a large stake in Mamma.com and avoided what later would have been a loss of about $700,000. The sale followed phone calls with Mamma officials in which Mr. Cuban, as the firm’s largest shareholder, was told about a coming PIPE offering. Those officials claimed that Mr. Cuban was told the information was confidential. There were remarks by Mr. Cuban, according to the complaint, which suggested he understood he could not trade. Yet the district court dismissed the complaint while offering the SEC an opportunity to file an amended action.

    The Commission stood firm on its complaint, declined to amend and appealed. The Fifth Circuit Court of appeals rewarded that perseverance, reversing the dismissal. The Court’s opinion was little more than a re-read and re-interpretation of the allegations penned by SEC in its complaint. What the district court saw as insufficient the Court of Appeals found to be adequate to move forward.

    The jury concurred with the district court – the allegations were not enough. This is a significant loss in a high profile case for the Commission. It is difficult to view it as not undercutting recent efforts to embolden the SEC enforcement program.

    To be sure the SEC recently won a significant victory in the its action against former Goldman Sachs employee Fabrice Touree. That victory, however, was preceded by losses in two major market crisis cases — one against Bruce Bent and others from Primary Reserve Fund and the other against Brian Stoker, former Citigroup employee. One win in four major cases is not a formula for bolstering an enforcement program. That record will not compel potential defendants to settle on the SEC’s terms rather than risk trial. That record does not create credibility. And, in the end, it is all about credibility.

    SEC Chair Mary Jo White Addresses Disclosure Policy

    October 15, 2013

    New SEC Chair Mary Jo White has addressed a series of topics in recent weeks, essentially outlining her vision for the Commission. Those remarks have delineated an enforcement doctrine, detailed her views on the role of an independent agency and outlined an approach to the markets. Now, in remarks to the National Association of Corporate Directors titled “The Path Forward on Disclosure (October 15, 2013), Ms. White addressed disclosure policy (here).

    “Without proper disclosure, investors would be unable to make informed decisions” Ms. White noted. “They would not know about the financial condition of the company they are investing in. Nor would they know about the company operations, who its board members are or what business, operational or financial risks the company faces . . .” Paraphrasing the Supreme Court’s seminal decision in TSC Industries v. Northway, she defined its “core purpose” as providing investors with the information necessary for making an investment or voting decision.

    Nevertheless, there can be “too much” disclosure the SEC Chair declared. There can be “’information overload’ – a phenomenon in which ever- increasing amounts of disclosure make it difficult for an investor to wade through the volume of information she receives to fret out the information that is most relevant.” This can result from rules or from professionals adding items such as long lists of risk factors to a filing.

    Returning to a point she made in earlier remarks about Dodd-Frank’s mineral disclosure requirements, Ms. White cited public hearings on disclosure held by the Commission not long before the Northway decision. In those hearings there were suggestions for disclosure regarding over 100 topics that included a “bewildering array of “special causes.” The Commission, however, focused on the core purpose of disclosure policy.

    Periodically over the years the Commission has updated disclosure policy. The JOBS Act provides a key opportunity for the Commission in this regard. It requires a review of disclosure requirements to consider how best to update, modernize and simplify the them. Currently the Division of Corporation Finance is finalizing a report which should be available soon.

    Moving forward there are a number of areas to consider and evaluate disclosure policy. These include:

    Updating: There may be a number of areas that need to be updated. For example, in view of the information available on the internet it may not be necessary to include certain information in filings. Likewise, the time period in which a filing is made might need to be considered.

    Repetition: In some instances the same information may appear in different places in a filing and it may be possible to streamline this.

    Industries: It may also be appropriate to revisit industry guides for specific disclosure keyed to certain industries.

    Predicate: It is also appropriate to consider the predicate for disclosure – that is, should it be rule based or principle based.

    In the end, the critical question is to determine if investors are receiving the information they need. While there is no one system that will satisfy everyone “our study regarding Regulation S-K will only be the first step, it will set the stage for the dialogue and path forward toward a meaningful review of our disclosure requirement” Ms. White concluded.

    SEC Enforcement: Is the Swagger Back?

    October 13, 2013

    The swagger is back according to SEC enforcement officials. Presumably that comment is meant to say that an enforcement program which once was viewed as among the best in government has returned to that rarified echelon. To be sure there is a lot of positive buzz about the program. New Chair Mary Joe White has in recent weeks addressed enforcement priorities (here), market structure (here) and last week what might be called enforcement omnipresence. But the swagger? Consider Ms. White’s most recent remarks at the Securities Enforcement Forum, Washington, D.C. (Oct. 9, 2013)(here).

    Remarks

    The focus of Ms. White’s remarks last week was omnipresence, that is, SEC enforcement will be like the 24/7 news cycle everywhere, all the time brining every case. While that is clearly not possible, the goal is to make it seem possible. The theory is simple: A cop on every corner brining charges for every violation no matter how small prevents wrongful conduct thereby making investors feel safe. As Ms. White stated: “I recognize the SEC cannot literally be everywhere, but we will be in more places than ever before. Our aim is also to create an environment where you think we are everywhere – using collaborative efforts, whistleblowers and computer technology to expand our reach, focusing on gatekeepers to make them think twice about shirking responsibilities, and ensuring that even the small violations face consequences.”

    There are four building blocks to the omnipresent strategy. The first is expanding the reach of the agency by leveraging its resources. This means utilizing resources like the National Exam Program to help uncover potential violations. Whistleblowers also become a key component since they can give Enforcement Division critical leads. All of this is supplemented by working with partners such as the DOJ, FINRA and state authorities.

    Technology can also help expand the reach of the agency. Specialized programs, coupled with big data, can aid enforcement efforts while expanding the horizon. In some instances the Commission is using analytics and related technology to conduct what the SEC Chair called “predictive analysis” to identify trends and streamline investigative efforts. In others specialized programs such as the Advanced Bluesheet Analysis Program for insider trading cases are used. That program “analyzes data provided to us by market participants on specific securities transactions. It identifies suspicious trading before market moving events. It also shows the relationships among the different players . . . “ said Ms. White.

    A second pillar of the strategy is to expand the focus on gatekeepers. One example of this focus is actions involving the boards of investment companies Those boards have a critical role in overseeing funds. Another is Operation Broken Gate, a recent initiative that focuses on auditors. Ensuring that gatekeepers fulfill their critical role, can help prevent violations of the law.

    The third facet of the approach centers encouraging respect for the law through what Ms. White called the “broken window.” If a window is broken an later repaired it demonstrates a commitment to the rules. If it is not, that fact suggests the opposite. To implement this approach the SEC will bring even small cases. A recent example it the series of strict liability actions based on short selling in violation of Regulation M.

    Finally, the agency will prioritize large cases. Here Ms. White pointed to the Financial Reporting and Auditing Task Force created earlier this year. The task force “brings together an expert group of attorneys and accountants who are developing state-of the-art techniques for identifying and uncovering accounting fraud.” Those cases are complex, resource intensive and time consuming, meaning it is essential that the agency prioritize them. By tying this point to the others, the SEC will endeavor to create the appearance of being “everywhere” to enhance enforcement.

    Analysis

    Putting a cop on every corner – or creating the appearance that there is one – is a proven law enforcement approach. The omnipresence formula is thus not new or novel. Neither are its building blocks. Leveraging resources has long been an approach used by the resource-short Commission. Focusing on gatekeepers is a theory that traces to the earliest days of the Enforcement Division. Prioritizing large cases is not so much a strategy as a necessity given the limited resources available to the SEC.

    The critical point here is how the building blocks are blended together. If the agency can effectively implement the theory it may become an effective enforcement approach. If omnipresence becomes an effective program it may be entitled to swagger. For now, however, it is all much like the poem Ode on a Greecian Urn penned long ago by the English poet John Keats’ – potential, in the offing and possible.

    This Week in Securities Litigation (Week ending October 11, 2013)

    October 10, 2013

    SEC Chair continued to define her vision for SEC enforcement this week, declaring that the agency will be the cop that is everywhere, filing large and small cases. This week the Commission resolved two insider trading cases, a cherry picking action and an offering fraud case.

    Transparency International issued its report on enforcement of the OECD Convention. The statistics in the report demonstrate that enforcement by member nations is at best uneven with the U.S., Germany, the U.K. and Switzerland leading the way. While the number of corruption cases brought by U.S. officials last year declined, the Report cautions that this only reflects the long term nature of the actions and not any decline in prosecution efforts.

    SEC

    Remarks: Chair Mary Jo White addressed the Securities Enforcement Forum, Washington, D.C. (Oct. 9, 2013). In her remarks she noted that the enforcement program will be the kind of cop that is everywhere, bringing large and small cases (here).

    Website: The Commission launched its new market structure data and analysis website which collects data from MIDAS this week.

    SEC Enforcement

    Weekly statistics: This week the Commission did not file or announced the filing of any civil injunctive actions or administrative proceeding (excluding follow-on actions and 12(j) proceedings).

    Insider trading: SEC v. Terpins, Civil Action No. 12-Civ-1080 (S.D.N.Y.) is the previously filed insider trading action centered on the acquisition of H.J. Heinz Company. Initially the action was filed against unknown traders. The amended complaint named as defendants two brothers, Michel Terpins and Rodrigo Terpins. The complaint alleges that Michel Terpins learned about the deal for Berkshire Hathaway and 3G Capital to acquire Heinz. The amended complaint does not specify how he learned this information. He then told his brother who placed the trades the day before the announcement through Alpine Swift, an off-shore investment vehicle with accounts in Switzerland. Rodrigo Terpins periodically attended performance meetings regarding Alpine Swift’s assets but he did not have permission to place the trades. The U.S. brokers for the vehicle had authorizations to make certain disclosures to federal regulators. The complaint alleges violations of Exchange Act Section 10(b). The defendants resolved the action, consenting to the entry of a permanent injunction prohibiting future violations of the Section cited in the complaint. They also agreed to pay disgorgement of $1,809,857, prejudgment interest and a $3 million penalty. See Lit. Rel. No. 22841 (Oct. 10, 2012).

    Cherry picking: SEC v. Dushek, Civil Action No. 13-cv-3669 (N.D. Ill. ) is a previously filed action against Charles J. Dushek, Charles S. Dushek and Capital Management Associates, Inc. The complaint alleges that the defendants engaged in a cherr picking scheme that made them about $2 million in illicit profits. This week the Court entered a final judgment as to each defendant which permanently enjoins them from future violations of Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2). The judgment also directs that each defendant pay disgorgement, prejudgment interest and civil penalties in an amount that will be determined later by the Court. See Lit. Rel. No. 22840 (Oct. 10, 2013).

    Offering fraud: SEC v. Laborio, Civil Action No. 1:12-cv-11489 (D.Mass.) is a previously filed action against, among others, Jonathan Fraiman. Last year the Commission filed an action charging Mr. Fraiman, two other individuals and seven entities, with raising about $5.7 million from more than 150 investors through a fraudulent unregistered offering of securities. Mr. Fraiman and the Commission resolved the matter and this week the Court entered a final judgment prohibiting him from violating Securities Act Section 17(a)(2), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 206(4)-8. The order also bars him from participating in any offering of a penny stock and requires him to pay disgorgement of $180,961.42 along with prejudgment interest. Payment was waived, and a penalty not imposed, based on financial condition. In a related administrative proceeding Mr. Fraiman consented to the entry of a bar from the securities industry with a right to apply reapply after ten years. See Lit. Rel. No. 22836 (Oct. 8, 2013).

    Insider trading: SEC v. Nguyen, Civil Action No. 12 Civ. 5009 (S.D.N.Y.) is a previously filed action against Tai Nguyen and his sister, ThanhHa Bao. The complaint alleged that from 2006 through 2009 Mr. Nguyen frequently traded on inside information about Abaxis, Inc., which he obtained from his sister who was employed at the company. This week the Court entered a final judgment by consent against Mr. Nguyen which prohibits future violations of Securities Act Section 13(a) and Exchange Act Section 10(b). The judgment also requires him to pay disgorgement of $144,910, prejudgment interest and a penalty equal to the amount of disgorgement. Those amounts will be credited against the sums Mr. Nguyen is required to pay in a parallel criminal action. In that case he was sentenced to serve one year in prison. Ms. Bao also settled with the Commission. The final judgment against her imposes a permanent injunction on the same terms as the one against her brother. In addition, the order bars her from serving as an officer or director of a public company for five years and requires the payment of a penalty of $144,900. See Lit. Rel. No. 22834 (Oct. 7, 2013).

    FCPA-Anti-corruption

    Transparency International issued its ninth annual progress report on OECD Anti-Bribery Convention Enforcement. “Exporting Corruption, Progress Report 2013: Assessing Enforcement of the OECD Convention on Combating Foreign Bribery.” The Report reviews the enforcement efforts by countries who are parties to the anti-bribery convention. While 40 countries are parties to the Convention, the Report makes it clear that global enforcement is quite uneven. For example, only the U.S., Germany, the U.K. and Switzerland were ranked as having active enforcement programs. Those four countries opened 62 investigations in 2012 compared to the 36 initiated by all of the other countries that executed the Convention. Likewise, those same four countries concluded 37 actions in which sanctions were imposed in 2012 while all of the remaining parties to the Convention resolved 3 such actions.

    Finally, in a section which analyzes FCPA enforcement, the Report notes that “the U.S. maintains the most developed and active foreign bribery legal and enforcement regime in the OECD (and the world).” Although last year there was a smaller number of actions against companies and individuals than in the prior year that does not represent a “de-emphasis of FCPA enforcement or a change in the legal or enforcement framework but rather the multi-year character of FCPA cases,” according to the Report. It does call for U.S. enforcement officials to provide more robust explanations for the reasons that an action is resolved with either a NPA or DPA.

    Circuit courts

    Note as a security: SEC v. Thompson, Case No. 11-4182 (10th Cir. Oct. 4, 2013) is

    a case which centers on the sale of notes in an alleged Ponzi scheme conducted by defendant Ralph Thompson through his company, Novus Technologies, LLC. The notes stated on their face that they were not securities. Nevertheless, the SEC prevailed on summary judgment. The key question on appeal was whether the notes were securities under Reves v. Ernst & Young, 494 U.S. 56 (1990). While the securities laws define the word security in broad terms which include a “note,” Reves made it clear that not every note is covered. Rather, that term must be viewed in the context of what Congress sought to accomplish under the securities laws. Under the Court’s decision generally notes are presumed to be securities. A four part test is used to compare the instrument to notes which are not securities. Critical to Appellant’s claims here is his contention that a jury must make the ultimate determination on this test. That claim is contrary to established Tenth Circuit and other authority which holds that it is a question of law, not fact, and that submitting it to a jury is error, at least in a civil case, the Court held. And, in any event, in view of the presumption that the note is a security, once a moving party demonstrates that there is no dispute of a material fact, the opposing party has the burden to demonstrate that the note is not a security.

    Here Appellant failed to rebut the presumption. The first question under the Reves test is the reasonable motivations of a buyer and seller of the instruments. Here the purpose was to raise money for the enterprise making it likely the instrument it is a security. Second, in the “plan of distribution” for it, the instrument need not be traded on an exchange. Rather, it is sufficient that it is sold to a broad segment of the public as here. Third, while the question of “reasonable perceptions of the investing public” is a closer call according to the Court, it also does not support Appellant despite the disclaimer on the notes in view of the overall analysis on the other factors. Finally, the last factor, which considers whether there is an alternate regulatory scheme, also cuts against Appellant. Here there is no other federal regulatory scheme to protect investors. Accordingly the decision of the district court was affirmed.

    FINRA

    Remarks: Richard Ketchum, Chairman and CEO of FINRA, addressed the Council for Economic Education, Baltimore, MD. (October 3, 2013). His remarks included comments on FINRA’s mission, a discussion of the financial literacy program and findings from a recent survey (here).

    PCAOB

    Brokers: The Board adopted two attestation standards regarding the audits of brokers and dealers (here).

    UK

    Misleading investors: Last week the Financial Conduct Authority censured Catalyst Investment Group for recklessly misleading investors in connection with the sale of bonds by ARM Asset Backed Securities SA from November 2009 through May 2010. This week the regulator imposed fines of £450,000 and £100,000 on, respectively, Timothy Roberts, the chief executive of the firm, and Andrew Wilkins, a former director of Catalyst Investment Group. Mr. Roberts was banned from the industry while Mr. Wilkins is precluded from holding senior roles in the future.

    Hong Kong

    The Securities and Futures Commission banned former representative Chan Ka Chung for life. Mr. Chun was found by a court that while he was an associate director at Falcon Private Bank Ltd. in Hong Kong that he conspired with two clients to issue four false letters showing proof of funds and credit facilities on the letterhead of the bank. The proof was not authorized by the bank. The court sentenced Mr. Chan to serve 23 months in prison.

    The Transparency International Report on Corruption Enforcement

    October 09, 2013

    Transparency International issued its ninth annual progress report on OECD Anti-Bribery Convention Enforcement. “Exporting Corruption, Progress Report 2013: Assessing Enforcement of the OECD Convention on Combating Foreign Bribery” (here). The Report reviews the enforcement efforts by countries who are parties to the anti-bribery convention. It thus provides insight into global enforcement efforts. While 40 countries are parties to the Convention, the Report makes it clear that global enforcement is quite uneven.

    Member countries are grouped in the Report into one of four categories based on their enforcement efforts: 1) Active enforcement; 2) moderate enforcement; 3) Limited enforcement; and 4) Little or now enforcement. Only four countries are included in the “active enforcement” category: the U.S., Germany, the U.K. and Switzerland. Collectively those countries commenced 62 active investigations in 2012, down from 86 in the prior year. During 2012 the U.S. opened 24 investigations, Germany 13, the U.K. 8 and Switzerland 19. That compares to 27 in the U.S., 32 in Germany, 11 in the U.K. and 16 in Switzerland during 2011.

    Italy, Australia, Austria and Finland were included in the “moderate enforcement” category. Collectively these countries opened 11 investigations in 2012 and in 2011. In 2012 Australia opened 10 inquires followed by Italy with 8 and Austria with 2 while Finland did not open an investigation last year.

    The final two categories – limited and little or now enforcement – include, respectively, 10 and 20 countries. In 2012 the 10 countries rated as conducting limited enforcement opened a total of 16 investigations compared to the 9 inquiries initiated by the 20 countries grouped in the little or no enforcement. Overall the four countries rated as conducting active enforcement opened 62 investigations in 2012 compared to the 36 initiated by all of the other countries that executed the Convention.

    The same patterns are evident in statistics regarding cases concluded last year. Here the four countries included in the active enforcement category resolved 37 cases with sanctions last year compared to 38 in the prior year. At the same time the moderate enforcement group only concluded 1 case with sanctions in 2012. The limited enforcement group concluded 2 such actions while the little to no enforcement group did not resolve any actions with sanctions. Overall the four countries which actively enforce the Convention concluded 37 actions in which sanctions were imposed while all of the remaining parties to the Convention resolved 3 such actions.

    Based on these statistics the Report makes three recommendations: 1) Government leaders must be asked to commit sufficient resources to enforcement; 2) The OECD Ministerial Meeting in the second quarter of 2014 should review enforcement; and 3) A meeting should be held with leaders of multinational enterprises and civil society organizations to enlist their support to overcome lagging enforcement.

    The final sections of the Report review enforcement programs in specific counties. Generally these sections review basis statistics and cases for the particular country an includes recommendations. In the section discussing the U.K., the Report notes that there is increasing use of civil recovery orders to resolve foreign bribery-related cases. This involves less judicial oversight and transparency compared to criminal plea agreements. There is also a willingness of the SFO to enter into confidentiality agreements which prohibits key information from being disclosed after cases are settled, according to the Report. The section concluded by expressing concern regarding future budget cuts at the SFO and the possible impact on enforcement.

    Finally, the Report notes that “the U.S. maintains the most developed and active foreign bribery legal and enforcement regime in the OECD (and the world).” Although last year there was a smaller number of actions against companies and individuals than in the prior year that does not represent a “de-emphasis of FCPA enforcement or a change in the legal or enforcement framework but rather the multi-year character of FCPA cases,” according to the Report.

    The Report also raised two points regarding U.S. enforcement. First, the U.S. has not made “sufficient progress” on the recommendation that the U.S. clarify its policy on dealing with claims for tax deductions for facilitation payments, and give guidance to help tax auditors identify payments claimed as facilitation payments that are in fact in violation of the FCPA . . .”

    The second recommendation focuses on the use of NPAs and DPAs. It notes that when resolving cases with these agreements the SEC and the DOJ should “make public detailed reasons on the choice of a particular type of agreement, the choice of the agreement’s terms and duration, and how a company has met the agreement’s terms.”

    SEC Prevails in Tenth Circuit

    October 08, 2013

    The SEC prevailed in a recent Tenth Circuit Court of Appeals ruling which upheld a grant of summary judgment in favor of the agency by the district court. The critical question before the Court was whether notes sold to investors were securities. In sustaining the Commission’s position, the Circuit Court held that the question is one of law which could be resolved on summary judgment, rejecting defense claims that the issue had to be considered by the jury. SEC v. Thompson, Case No. 11-4182 (10th Cir. Oct. 4, 2013).

    The case centers on an alleged Ponzi scheme conducted by defendant Ralph Thompson through his company, Novus Technologies, LLC. That entity was founded in 2000 by Mr. Thompson as a vehicle for his investments. To implement his plans Mr. Thompson needed to raise $12 million.

    Over time Mr. Thompson became involved with two investment programs which were supposed to generate huge returns. One was a proprietary algorithm for trading on the S&P 500 that was claimed to give investors monthly returns of 5% to as much as 40%. The second was a real estate investment program that its investors claimed would guarantee investors returns of 10% per month. Later a third real estate program was added.

    To raise money unsecured promissory notes were sold. Those notes provided for repayment after a term of six months plus monthly interest of 3% to 5%, depending on certain options selected by the investor. The notes also stipulated that the borrower could extend the term for a period of six months as long as the interest was paid. The instrument stated on its face that it was not a security.

    Mr. Thompson marketed the notes, claiming that they represented a more conservative investment than a 401(k) or a mortgage. Investors were told about the reserve of cash and assets held by Novus to cover any money borrowed. Sales continued until April 2007 when the SEC filed suit and obtained a freeze order. Subsequently, the district court granted summary judgment in favor of the SEC on its fraud claims.

    The critical question on appeal was if the notes were securities within the meaning of the Supreme Court’s decision in Reves v. Earnst & Young, 494 U.S. 56 (1990). While the securities laws define what constitutes a security in broad terms which include a “note,” Reves made it clear that not every note is covered. Rather, that term must be viewed in the context of what Congress sought to accomplish under the securities laws. To assess this point the Supreme Court adopted a version of the Second Circuit’s “family resemblance test. Under this approach a note is presumed to be a security, although it left the question open for those instruments which have a term of less than six months. The presumption can only be rebutted if the instrument resembles those which are in fact not securities. Those include notes delivered in consumer financing, with a home mortgage, those which are short term or which are associated with an open account debt incurred in the ordinary course of business.

    The application of the resemblance test is governed by four factors under Reves. First, the court must consider the motivations of the purchaser and seller to the transaction. Second, the “plan of distribution” of the instrument must be evaluated with a view to whether there is common trading for speculation or investment. Third, the reasonable expectations of the investing public must be considered. Fourth, the question of whether some factor such as the existence of another regulatory scheme which significantly reduces the risk of the instrument and makes protection under the securities laws unnecessary must be evaluated. If the application of this test suggests that the instrument is not sufficiently analogous to one on the list, then consideration must be given to if another category should be added which would again require analysis using the four factor test.

    Critical to Appellant’s claims here is his contention that a jury must make the ultimate determination on the family resemblance test. This claim is contrary to established Tenth Circuit and other authority which holds that the question is one of law, not fact, and that submitting it to a jury is error, at least in a civil case. While there may be factual issues involving the application of the family resemblance test, the Court held “that in the context of a civil case where the ‘security’ status of a ‘note’ is disputed, the ultimate determination of whether the note is a security is one of law; thus, resolution of factual disputes will be necessary only in those rare instances where the reviewing court is unable to make a proper balancing of the family-resemblance factors without resolving those factual disputes.” And, in view of the presumption that the note is a security, once a moving party demonstrates that there is no dispute of a material fact, the opposing party has the burden to demonstrate that it is not.

    Here Appellant failed to rebut the presumption. The first question is the reasonable motivations of a buyer and seller of the instruments. Where, as here, the purpose is to raise money for the use of the enterprise or to finance investments, it instrument is likely a security.

    Similarly, consideration of the second and third factors also fails to support Mr. Thompson. In evaluating the “plan of distribution” it is not necessary that the notes be traded on an exchange. Rather, it is sufficient that they are sold to a broad segment of the public as here. While the issue regarding the “reasonable perceptions of the investing public” is a closer call, it also does not support Appellant. The instruments were characterized as “investments.” While the notes did state that they were not securities, in view of the perceptions of the public this one factor will not, according to Reves, outweighs the others if, as here, they suggest the notes are securities.

    Finally, the last factor, which considers whether there is an alternate regulatory scheme, also cuts against Appellant. In this regard the Court held that “If the instrument ‘would escape federal regulation entirely if the Acts were held not to apply,’ the fourth factor cuts toward characterizing the instrument as a security.” Here this is precisely the case. Accordingly, the Court affirmed the decision of the district court.

    SEC Independence: The Political Process, Rule Making and The Courts

    October 07, 2013

    In three recent addresses SEC Chair Mary Jo White has given definition to her vision for the agency. In one, she discussed Enforcement policy (here). A second focused on market structure (here). In a third, titled The Importance of Independence, delivered to the 14th Annual A.A. Summer, Jr. Corporate Securities and Financial Law Lecture, Fordham Law School (October 3, 2013)(here), Ms. White focused on the meaning of being independent. While many of her comments on independence reiterate the basics, her views on the settlement of enforcement actions are significant.

    The remarks

    “Under the law the SEC is an independent agency . . . “ Ms. White began. That “does not mean that the SEC does not listen to the ideas and recommendations that come from beyond our building. Indeed, we depend upon hearing and evaluating the ideas and recommendations of those who will be impacted by our rules. . . At the end of the day, however, we make our decisions based on an impartial assessment of the law and the facts and what we believe will further our mission. . . “

    With this preface Ms. White outlined her view of independence in three contexts: 1) political; 2) rule making and 3) enforcement settlements. Drawing on her experience as a U.S. Attorney, Ms. White stated that while Commissioners are appointed through the political process, their job is to make decisions on the facts, implementing the mission of the agency. The SEC, Ms. White declared, has a strong tradition of being independent of the political process. In support of this point she cited examples of actions taken by former Chairman over the years.

    Independence comes not just from inside the SEC’s building however. Rather, it “should be respected by those outside, including the industry, other agencies, Congress and the courts.” In the context of rule making this means that “the agency’s unique expertise – should be, for example, respected by those who seek to effectuate social policy or political change through the SEC’s power of mandatory disclosure. “

    It is essential in implementing disclosure policy that the agency “shape disclosure rules consistent with the federal securities laws and its core mission.” In some instances Ms. White stated that she may question if the Commission’s disclosure mission should be utilized to implement policy. One example is the Dodd-Frank mandate that the agency write disclosure rules regarding conflict minerals. While Ms. White allowed that this may be good social policy, she questions using the federal securities laws as a mechanism to implement it.

    Nevertheless, “I recognize that when Congress and the President enact a statute mandating such a rule, neither I nor the Commission has the right to just say ‘no.’” We cannot say that a law does not comport with our mission as we see it. . . .” Rather, the question is what leeway the law affords the agency in writing the rules. It is the responsibility of the agency to utilize its expertise within that context, according to the SEC Chair.

    Finally, Ms. White “urge[d] the courts to defer to the SEC’s independence and expertise.” This means in the first instance the deference that is due under decisions such as Chevron.

    Turning to the question of requiring admissions as part of a settlement while declining to comment on any pending cases, Ms. White reiterated the parameters of her new policy. In select instances the Commission will demand admissions a part of the settlement of an enforcement case. At the same time the “neither admit nor deny” formulation will continue to be an important tool in resolving those cases. The decision to either policy is one for the agency in its discretion, not the courts Ms. White stated. Acknowledging that under the law the court can review a settlement, its role is limited: “A court reviewing a consent judgment in one of our cases has a narrow focus – making sure that the settlement is not ambiguous and that it does not affirmatively harm third parties or impose undue burden on the court’s own resources.”

    Analysis

    The notion that the SEC is independent and should make decisions based on the merits and not on politics is axiomatic and fundamental to its core mission. Equally clear is the fact that the SEC is obligated to write rules within the context directed by the statutes written by Congress and signed by the President. As Ms. White noted, regardless of the personal views of Commissioners on the wisdom of certain statutory directives, it is the responsibility of the agency under the law to write the rules as directed.

    Less clear, however, is Ms. White’s vision of the court’s role in effectuating an enforcement settlement. The basic premise that the implementation of agency policy is within the sound discretion of the regulator should not be controversial, although that issue may be given new definition when the Second Circuit resolves the pending Citigroup case on the role of the courts in SEC settlements (here). Accordingly, the question of whether admissions should be sought or the settlement can be effected on a neither admit nor deny basis should typically fall within the discretion of the agency. Stated differently, whether one settlement policy or another is employed should generally be reserved to the discretion of the agency.

    At the same time it is difficult to view the court’s role as limited to little more than proof reading, checking to see that the papers are clear and ensuring that the arrangement will not cause harm or be burdensome. As Judge Gleeson remarked in holding that the court had authority to approve a deferred prosecution agreement in U.S. v. HSBC Bank USA, N.A., Case No. 12-cr-763 (E.D.N.Y. Order dated July 1, 2013)(here), it is the parties who chose to file the case with the court and invoke its authority. It is the parties who came before the court and asked it to take certain actions. In taking those steps the parties submitted themselves to the authority of the court and its supervisory powers.

    This is particularly true of most Commission enforcement settlements. In those cases it is the SEC that invokes the jurisdiction of the court by filing the action. Likewise, it is the SEC requesting that the court enter certain orders which can then be enforced through its contempt power. Viewed in that context the Court cannot be reduced to what Judge Gleeson called – citing a now famous statement – a potted plant.