by T. GormanPosted on Posted in SECActions

Every SEC investigation potentially involves questions about the attorney-client privilege, the work product doctrine and inadvertent waiver. The typical investigation begins with a broad-based request for documents. The proposed time frame for the production is typically circumspect. Not infrequently the production will require the responding party to produce a large quantity of documents which may number in the hundreds of thousands if not the millions of pages. Today many, if not most, of those materials will be electronic. The task of sorting those materials, culling those which are responsive to the subpoena and excluding others protected by the attorney client privilege and the work product doctrine under a tight deadline can be daunting.

What happens if errors are made? Is the privilege waived because in an effort to quickly sort millions of pages of electronic documents privileged materials are produced? The recent decision in SEC v. Welliver, Civil No. 11-CV-3076 (D. Minn. Ruling Oct 26, 2012) provides insight into these questions and a caution to parties responding to Commission subpoenas and to the agency.

The Commission’s action in Weliver centers on a claimed breach of fiduciary by defendants David Welliver and Dblaine Capital, LLC in connection with a loan involving Lazy Deuce Capital, Co. and Sematia Partners LlC. Specifically, Dblaine Fund, advised by Dblaine Capital, obtained a $4 million loan from Lazy Deuce and Sematia Partners in return for agreeing to invest significant mutual fund assets in “alternative investments” recommended by Lazy Deuce. Mr. Welliver controlled Dblaine Capital, a company he founded and for which he has acted as CEO and CIO. That company advises Dblaine Investment Trust, a registered investment company that has multiple funds including Dblaine Fund.

During the course of the litigation the SEC filed a motion requesting that the court find defendants waived their attorney client privilege as to communications involving attorney Wanda Weber. During the pre-complaint investigation the defendants produced a series of e-mails involving communications between Ms. Weber and Mr. Welliver or between Ms. Weber, Mr. Welliver and David Jones, the Chief Compliance Officer of Dblaine Investment Trust. The materials were produced on August 1, 2011, just after the July 28, 2011 deadline set by the subpoena. After the filing of the complaint the defendants produced as part of the discovery e-mails involving the same parties. Some e-mails involving those parties were introduced as exhibits at the deposition of Mr. Jones by the defendants. At the time the defendants had pleaded defenses asserting that they relied on advise from an array of professionals including counsel.

After a change of defense counsel defendants sought to claw-back the attorney client communications, claiming inadvertent production. The defenses were amended, deleting the reliance on counsel. The SEC refused to return the materials, claiming waiver.

The Court granted the Commission’s motion, concluding the defendants had waived privilege as to the produced documents. Since the SEC’s motion assumed that the documents were privileged, the Court treated the question as one of waiver. While neither party cited Rule 502 of the Federal Rules of Evidence, the Court concluded at the outset that its provisions apply. That Rule governs the scope of a waiver when a disclosure is made in a federal proceeding or to a federal agency. It provides that there is only a waiver if: “(1) the waiver is intentional; 2) the disclosed and undisclosed communications or information concern the same subject matter; and 3) they ought in fairness to be considered together.” It goes on to provide that a disclosure is not a waiver if: “(1) the disclosure is inadvertent; 2) the holder of the privilege . . . took reasonable steps to prevent disclosure; and (3) the holder promptly took reasonable steps to rectify the error . . . “

Under Rule 502 the scope of any waiver depends on “whether the waiver of the privilege . . . is intentional or inadvertent,” according to the Court. If the waiver is inadvertent it is limited to the materials produced. The waiver can, however, be broader if that is “made necessary by the intentional and misleading use of privileged or protected communications or information” the Court ruled. That would occur where the disclosing party sought to utilize the material for a tactical advantage. This differs significantly from the common law rule under which the act of disclosure constituted a waiver by subject matter.

Following these principles the Court concluded that there was a waiver of privilege as to the materials produced at the Jones deposition. The disclosure there was clearly intentional. The record here, however, did not support a claim that there should be a subject-matter waiver. Neither party described the context in which the materials were used which might suggest a basis for such a ruling.

The Court also concluded that there had been a waiver as to the materials produced in response to the SEC investigative subpoena and in discovery. Under the Rule the critical point is the reasonableness of the precautions taken, the time taken to rectify the error and the overriding fairness, the same approach utilized in pre-Rule case law in the district.

In this case the Court found that “the record is devoid of any mention of a review conducted, precautions taken, or extensions requested by Defendants in either disclosure.” While the defendants did claim that the disclosures should be excused because of the SEC’s “aggressive and unreasonable timeframe for production” the Court noted that no extension was ever requested and the defendants failed to discuss any procedural steps taken to protect privileged material.

The Court went on to find that many of the same documents were disclosed in each production and the defendants failed to take any steps to promptly rectify the claimed error beyond finally serving a claw-back letter. Under the circumstances, the “interests of fairness and justice would not be served” by relieving the Defendants of the consequences of their actions.

The Court came to a similar conclusion regarding the affirmative defenses. While those defenses were amended to eliminate an express reliance on counsel, those remaining turn on a “knowledge of the law and the legality of their actions . . .” the Court found. Accordingly, the amendments did not preclude the limited waiver of privilege here.

The Court’s ruling in Welliver should serve as a clear caution to counsel representing a subpoena recipient in an SEC investigation as well as to the Commission. While an SEC investigative subpoena requires the prompt production of the responsive non-privileged materials, at the same time counsel must take care to institute the appropriate procedures to protect privileged materials. Those procedures should be reasonably designed to identify and cull out privileged materials. Where appropriate the procedures may require that a reasonable extension of the compliance date be sought. When such a request is made it should be carefully documented along with the reasons and the response of the staff along with each other steps taken to protect privileged materials for use if a claw-back motion becomes necessary.

At the same time Welliver suggests that Commission counsel should carefully consider the time limits imposed by investigative subpoenas. Not permitting sufficient time for counsel to sift out privileged material may be grounds for a later claw-back request if privileged material in inadvertently produced. Being required to give back privileged material may ultimately damage the Commission’s case, particularly if they have been used to develop other evidence or support important claims in the action. In the end, Welliver teaches that Commission counsel, and those responding to SEC investigative subpoenas, proceed not just expeditiously but in a careful manner which ensures that there is sufficient time to protect attorney client and work product material.

Hurricane Sandy: To aid the victims of Sandy’s destruction please donate to the Red Cross, here.

Seminar: The ABA’s premier program on securities fraud, the National Institute on Securities Fraud, will be held on November 15 and 16, 2012 in New Orleans (here).

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by T. GormanPosted on Posted in SECActions

The Supreme Court heard argument in a significant securities case this week. The question the High Court will resolve later this term is whether a securities law plaintiff relying on the fraud-on-the-market theory must, at the class certification stage, prove that the claimed misstatements were material. The district court and the Ninth Circuit held that the plaintiffs were not required to establish materiality at certification.

SEC Enforcement filed three actions this week. One centered on an offering fraud, a second is based on a market manipulation claim while the third involved an investment adviser concealing market crisis losses.

The SEC

Remarks: Norm Champ, Director, Division of Investment Management, addressed the ALI CLE 2012 Conference on Life Insurance Products, Washington, D.C. (Nov. 1, 2012). His remarks reviewed the recent financial literacy study, the new investor advisory committee, a new risk based approach the Division will employ and product changes (here).

The Supreme Court

The Court heard arguments in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, Docket No. 11-1085. The question for resolution is whether a securities law plaintiff must demonstrate that the claimed misrepresentations are material at the class certification stage in a fraud-on-the-market case.

The resolution of this question is at the intersection of Rule 23, Federal Rules of Civil Procedure, and the Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988). The Rule governs class certification and in subsection (b)(3), central here, requires that the issues common to the class members predominate to permit the case to move forward as a class action. Basic held that a plaintiff can establish the element of reliance on the misrepresentations by utilizing a rebuttable presumption that purchasers relied on the integrity of the market if it is efficient so that a material misrepresentation would be reflected in the price. In essence, the presumption establishes transaction causation, linking the purchaser and the misrepresentation.

Three themes dominated the arguments. First, the critical point under Rule 23(b)(3) is whether the issues common to the class members predominate. When they do the class can be certified. The text of the Rule makes no reference to the merits of the claim. Second, Basic requires that the securities law plaintiff establish that the market is efficient and that the misrepresentation is material to employ its rebuttable presumption. If the misrepresentation is not material by definition it will not impact the market and there can be no presumption. Third, in earlier cases the High Court has hewed close to the text of Rule 23 when considering the class certification question, concluding that the plaintiff need not turn the certification hearing into a resolution of the merits.

Essentially Petitioners claimed that contrary to the ruling by the Ninth Circuit, at certification plaintiffs should be required to establish the materiality of the claimed false statements under Basic. Respondents and the government rejected this contention, arguing that under Rule 23 the issue is common questions among the class permitting certification while materiality is a merits issue.

SEC Enforcement: Filings and settlements

Statistics: This week the Commission filed 3 civil injunctive actions and no administrative proceedings (excluding tag-a-long and 12j actions).

Offering fraud: SEC v. McDuffie, Civil Action No. 1:12-cv-02939 (D. Colo. Filed Nov. 8, 2012) is an action against Stanley McDuffie and his controlled entity Jilapuhn, Inc. d/b/a Her Majesty’s Credit Union. Beginning in 2008 defendants used the website www.hmcu.net to lure investors to purchase certificates of deposits in what was claimed to be a credit union. The certificates were supposed to pay substantial interest and be guaranteed by Lloyd’s of London. In fact the CDs were fraudulent and the $532,000 of investor funds were put in a for profit company controlled by Mr. MCDuffie and misappropriated. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). The case is in litigation. See also Lit. Rel. No. 22526 (Nov. 8, 2012).

Manipulation: SEC v. Cole (S.D.N.Y. Filed Nov. 8, 2012) is an action against Lee Cole, Linden Boyne, Kevin Donovan and Timothy Quintanilla. Over a three year period beginning in 2006 Messrs. Cole and Boyne, serving as, respectively CEO and CFO, of Electronic Game Card, Inc. made misrepresentations regarding the financial condition of the company. They claimed, for example, that it had a bank account worth over $10 million, held investments worth millions of dollars and had significant annual revenues. In fact the bank account did not exist and the investments were in entities controlled by Messrs. Cole and Boyne. While making these misrepresentations the stock price soared. Messrs. Cole and Boyne funneled millions of shares off shore where they were sold. Throughout the period outside auditor Quintanilla issued unqualified audit opinions that falsely claimed to be in accord with PCAOB standards, according to the complaint. After much of the activity in the complaint concluded, Kevin Donovan became CEO of the company. He repeated the same false representations to investors while ignoring numerous red flags. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10A(a)(1), 10A(b)(1), 10(b), 13((a), 13(b)(2)(A), 13(b)(5), 13(d) and 16(a). The case is in litigation

Market crisis: SEC v. Morales (M.D. La. Filed Nov. 8, 2012) is an action against registered investment adviser Commonwealth Advisors, Inc. and Walter A. Morales, its founder and current sole-owner. Beginning in 2007 defendants engaged in a scheme to conceal huge losses suffered from holding residential mortgage-backed securities or RMBS. Those investments deteriorated in value as the market crisis unfolded. Rather that disclose the losses, Mr. Morales had the funds advised execute dozens of manipulative cross-trades which benefited some investors to the detriment of others in an effort to conceal the losses. When confronted by a large shareholder to whom Mr. Morales represented that the fund would not hold more that 10% of its assets in RMBS at a time when the concentration far exceeded that point, the investor was given false board minutes. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2) and 204 and 206(4). The case is in litigation.

CFTC

Statement: Commissioner Bart Chilton issued a statement regarding the Commission’s Dodd-Frank rule making proposals. It states that the agency has finalized about two thirds of the required 60 rules and provides a list along with projected dates for the remaining work to be done (here).

FINRA

Manipulation: The regulator expelled Hudson Valley Capital Management and barred its CEO, Mark Gillis from the securities business. In 2012 the firm, through Mr. Gillis, used its Average Price Account to improperly day trade millions of dollars of stock. Mr. Gillis manipulated the share price of those stocks and withdrew the proceeds. When there were losses he covered them by making unauthorized trades in customer accounts. Mr. Gillis also converted customer funds. The firm, which failed to supervise him, had a net capital deficiency of over $350,000 as a result of the scheme.

Investment fund fraud: The regulator brought a proceeding against WR Rice Financial Services and its owner, Joel Wilson to halt on-going sales activity and the conversion of investor funds. Investors were solicited by the firm, its owner and representatives to invest in land contracts on residential real estate in Michigan which carried an interest rate of 9.9%. In fact the firm and its owner diverted the funds to make unsecured loans to companies owned or controlled by Mr. Wilson. Investors were also not told that there was no ability to pay the loans when they came due. Mr. Wilson was also charged with providing fabricated documents to FINRA during its investigation and incomplete testimony. The proceeding will be scheduled for hearing.

FSA

Investment fund fraud: The SFO announced that city stockbroker David Andrew Levene was sentenced to serve 13 years in prison after pleading guilty to 12 counts of fraud, one count of false accounting and one count of obtaining a money transfer by deception. From April 2005 through October 2009 Mr. Levene solicited money from investors that was supposed to be invested in various securities. Instead he diverted the investor funds to his personal use. Over the period he raised about ₤250 million from investors. In part the money was used to repay investors which kept the scheme from being discovered for a period of time. In part it was diverted to pay for Mr. Levene’s personal expenses and travel. The scheme unraveled when investors brought suit to recover their money. Subsequently, Mr. Levene was made the subject of a bankruptcy order. Investor losses are estimated to be over £32 million.

Hurricane Sandy: To aid the victims of Sandy’s destruction please donate to the Red Cross, here.

Seminar: The ABA’s premier program on securities fraud, the National Institute on Securities Fraud, will be held on November 15 and 16, 2012 in New Orleans (here).

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