The Impact of the New Commission Cooperation Initiatives – Part II

The SEC’s new cooperation tools have impacted a number of actions. In four cases, as discussed in Part I of this article, the Commission entered into agreements under which it either chose to prosecute or deferred prosecution with a view toward dismissal. In most instances where the agency has acknowledged the cooperation of a party however, an action was brought but the resolution of the case was altered in some fashion.

Reduced sanction

In some cases the Commission acknowledged cooperation while imposing a reduced sanction as in the proceeding against BNY Mellon Securities LLC, In the Matter of BNY Mellon Securities LLC, Adm. Proc. File No. 3-14191 (January 14, 2011). There the Order alleged that the registered broker dealer failed to reasonably supervise the manager on its institutional order desk and the traders under his supervision over a seven year period. During the period the order desk manager failed to meet his duty of best execution to certain customers. Orders were executed at stale or inferior prices which were frequently outside the National Best Bid and Offer at the time of execution. In some instances the orders were executed in cross-trades with a favored handful of accounts held by hedge funds and certain individuals. While the firm did have written procedures, there were none to follow-up on red flags. The Order thus alleged that the firm failed to reasonably supervise within the meaning of Exchange Act Section 15(b)(4)(E) with a view to preventing and detecting violations of Section 17(a).

The broker dealer settled the proceeding, consenting to the entry of a censure. BNY Mellon Securities also agreed to pay disgorgement of $19,297,016, prejudgment interest and a $1 million penalty and to implement certain procedures. The Commission settled on these terms in view of the cooperation and remedial efforts of the broker-dealer which included: 1) Suspending cross-trading and beginning an internal investigation three days after one of the hedge funds involved was charged on an unrelated matter; 2) Terminating the order desk manager for cause; and 3) Self-reporting about two and one half months after commencing its investigation. See also: In the Matter of AXA Advisors, LLC, Adm. Proc. File No. 3-14708 (Jan. 20 2012)(failure to supervise action where employee induced clients to redeem accounts so he could misappropriate funds resolved with censure, adoption of procedures and payment of $100,000 penalty based on cooperation, adoption of procedures and retention of independent consultant);

No penalty

In other instances the SEC has elected not to impose a financial penalty based on the cooperation of the company. A good example of this small group of cases is the proceeding against Arthrocare Corporation, a medical device manufacturer. In the Matter of Arthrocare Corporation, Adm. Proc. File No. 3-14249 (Feb. 9, 2011). There the Order Instituting Proceedings alleged that over a three year period the company inflated its income by overstating and prematurely recognizing revenue primarily in connection with quarter end sales to one customer. The purpose was to meet quarterly goals and street expectations. Eventually Arthrocare was required to restate its financial statements.

The proceeding was settled with a consent to the entry of a cease and desist order which prohibits future violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). No fine was imposed based on the cooperation and remedial efforts of the company which included: 1) Replacing the senior management team; 2) expanding its legal department; 3) creating a position for and hiring a new Compliance Officer position; 4) hiring a new corporate controller and international controller; 5) expanding its internal audit function; 6) instituting quarterly ethics communications from senior management to employees; 7) implementing a sub-certification process as part of its quarterly and annual financial reporting; 8) adopting standard customer contracts with rigorous approval requirements; 9) hiring a contract administrator; and 10) providing regular training on proper revenue recognition and accounting for handling contracts.

During the investigation the company regularly updated the staff on its internal investigation; provided critical documents without waiting for a request; promptly responded to staff requests; routinely granted the staff access to the company’s consulting expert; voluntarily produced witness for testimony who were outside the U.S; and provided the staff with a detailed analysis of its restatement.

Similarly in In the Matter of Fifth Third Bancorp, Adm. Proc. File No. 3-14639 (Nov. 22, 2011) the proceeding was settled with a consent to the entry of a cease and desist order, in this instance based on Exchange Act section 13(a) and Reg FD but no penalty based on the Respondent’s cooperation. The underlying proceeding was based on allegations that the bank selectively disclosed to certain investors that it planned to redeem a class of its trust preferred securities for about $25 per share.

The Order acknowledge “the remedial acts promptly and voluntarily undertaken by Fifth Third – including its compensation of CAP VII TruPS investors harmed by the timing of the disclosure and its adoption and implementation of additional policies and procedures . . .” and the cooperation afforded the staff. In other cases the Commission has made similar statements. See, e.g., In the Matter of GSCP (NJ), Adm. Proc. File No. 3-15514 (Aug. 25, 2011)(no fine imposed on investment adviser that served as portfolio manager for sale of synthetic CDO where the marketing materials failed to disclose the participation of a hedge fund in selecting collateral that had a short position); SEC v. Cinderey, Civil Case No. CV 12-1519 (N.D. Cal. Filed March 27, 2012)(settled action in which bank officer who participated in scheme to circumvent controls to delay recognition of loan losses settled by consenting to an injunction but was not required to pay a civil penalty based on cooperation and fact that he paid a $40,000 fine in an FDIC administrative proceeding).

Reduced penalty

In other instances cooperation resulted in a reduced fine as in In the Matter of Martin Currie, Inc., Adm. Proc. File No. 3-14873 (May 10, 2012). There an investment adviser used assets of one client to rescue another in violation of Advisers Act Sections 206(1) and (2) and Investment Company Sections 17(d) and 34(b). The matter was resolved with a cease and desist order, censure and the payment of an $8.3 million fine. The fine was limited because of cooperation which included: Compensating the fund injured; refunding fees; terminating and/or disciplining those involved; conducting an investigation; and implementing procedures. Similarly in SEC v. Easom, Civil Action No. 2:11-CV-7314 (D.N.J. Filed Dec. 16, 2011) a corporate insider who tipped a cousin – broker who then tipped others entered into cooperation agreement. As a result the insider settled by consenting to a fraud injunction and paying disgorgement of $327 in trading profit and prejudgment interest but only a $10,000 civil penalty. See also SEC v. Wrangell, Case No. 7:12-cv-00274 (E.D.N.C. Filed Sept. 20, 2012)(tippee in insider trading case cooperated and settled by consenting to a fraud injunction, disgorging his trading profits of over $42,000 and paying a reduced penalty of $11,380.99); SEC v. Rooks, Civil Action No. 1:12-cv-02988 (N.D. Ga. Filed Aug. 28, 2012)(same).

Finally, in some instances while the Commission has acknowledged cooperation and apparently mitigated the penalty, but the impact is not readily apparent. SEC v. Pressetek, Inc., Civil Action No. 10-1058 (E.d.N.Y. Filed march 9, 2010) is such a case. There the company was charged with violations of Exchange Act Section 13(a) and Reg FD. The action centered on conversations about the performance of the company by its chairman and CEO with an investment adviser to a fund which owned a substantial block of Pressetek stock.

In an unusual step, the complaint acknowledged the cooperation of the company and its remedial acts which included revising its corporate communications policies and governance principles, replacing its management team, appointing new independent board members and creating a whistleblower hotline. Nevertheless, the company settled with the Commission by consenting to the entry of a permanent injunction prohibiting future violations of the Sections cited in the complaint and paying a $400,000 fine. The impact of the cooperation was not specified.

Similarly, in SEC v. Long-Short term, Inc., Civil Action No. 1:11-cv-1127 (E.D.Va. Filed Oct. 18, 2011), an action based on false statements made during options trading seminars, the Commission acknowledged the cooperation of the defendants and noted that they retained counsel who evaluated the company, instituted new policies and installed procedures to prevent a reoccurrence. Yet both defendants consented to the entry of permanent injunctions prohibiting future violations of Exchange Act Section 10(b). The company paid a penalty of $750,000 while the co-founder paid $150,000. See also In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Admin. Proc. File No. 3-14204 (January 25, 2011)(misuse of customer order flow information, improper mark-ups and downs results in failure to supervise charge settled with cease and desist order and civil penalty of $10 million, although cooperation acknowledged); In the Matter of JSK Associates, Inc., Adm. Proc. File No. 3-14296 (March 14, 2011)(investment adviser and two others charged in action based on failure to disclose compensation; each settle by consent to cease and desist order; adviser paid disgorgement of over $60,000; and individuals each paid civil penalty of $10,000; resolution based on prompt cooperation and remedial efforts).

Conclusion

The Commission’s new cooperation tools have been employed in a series of cases. Few have resulted in either a non-prosecution or deferred prosecution agreement. The circumstances under which either of these types of agreements have been utilized are limited, typically reflecting the type of case on which the 2002 Seaboard Release was based.

Yet there seems to be little reason for restricting the use of these agreements to such limited circumstances. Seaboard represented a decision not to prosecute. There was no formal mechanism to obtain disgorgement, impose a civil penalty or insure the implementation of remedial measures to prevent future violations.

The Commissions new cooperation tools solve this dilemma. With either a non-prosecution or deferred agreement the agency can obtain as part of the arrangement disgorgement, a civil penalty and require the implementation of policies and procedures which can help prevent future repetition. Indeed, a deferred prosecution agreement can serve as a kind of time limited mini-injunction, conditioning dismiss at a future point in time on: 1) The payment of disgorgement and/or a penalty as appropriate; and 2) the continued implementation of policies and procedures which reform the company and its culture to prevent a future reoccurrence of the wrongful conduct. Accordingly, there is no reason not to broaden the application of these tools which would better serve their goal of encouraging self-reporting and cooperation while speeding investigations.

Finally, while in many instances the Commission has detailed the cooperation and remedial efforts involved, that is not true in each case. A better explication of the efforts which earned the company “cooperation credit” and a reduced sanction provides added guidance to the market place encouraging cooperation. Overall, experience to date suggests that these initiatives represent the adoption of new tools which will well serve the enforcement program in the future.

Hurricane Sandy: The President suggested that those who want to aid the victims of this devastating storm contribute to the Red Cross. The link is here.

Seminar: The ABA’s premier Securities Fraud seminar will be held in New Orleans on November 15 and 16, 2012 (here).

The Impact of the New Commission Cooperation Initiatives – Part I.

Cooperation was a major tenant in the retooling of the SEC’s enforcement program. Borrowing heavily from the Department of Justice, the Commission announced proposals to use non-prosecution agreements and deferred prosecution agreements to encourage cooperation in 2010. While the emphasis was on individuals, issuers were included. The idea was to encourage cooperation to speed investigations.

It has been almost two years since the first non-prosecution agreement was entered into by Atlanta based clothing manufacturer Carter’s, Inc. Since then the Commission has entered into one other non-prosecution agreement and two deferred prosecution agreements. It has also acknowledged that cooperation impacted the settlement in a number of other cases.

To assess the impact of the new cooperation proposals key, cases in which cooperation has been acknowledged by the Commission will be assessed. Those actions can be divided into three groups for discussion purposes: 1) Non-prosecution agreements; 2) deferred prosecution agreements; and 3) settled actions in which the Commission has acknowledged that cooperation impacted the resolution. The first two groups will be considered in this article while the remaining actions along with an assessment of the initiatives will be in an article published later this week.

No prosecution

Since the announcement of the proposals, the Commission has only entered into two non-prosecution agreement and two deferred prosecution agreements. The former were with Carter’s, Inc. and an executive at investment advisor AXA Rosenberg. The latter were with Tenaris S.A. and the Amish Help Fund.

The Commission’s first non-prosecution agreement arose out of the financial fraud at Carter’s, Inc. There senior executive Joseph Ellis manipulated certain industry standard rebates or discounts that were given to a large customer. Specifically, Mr. Ellis is alleged to have granted larger than appropriate rebates or discounts to induce larger sales. He concealed his actions with false documents, causing the revenue of the company to be significantly overstated for a period. When the scheme was announced the share priced dropped significantly. Mr. Ellis has been named in both civil and criminal actions. Two other executives have also been charged by the Commission.

Carter’s, Inc., was not prosecuted in view of its cooperation. Rather, the company entered into the first non-prosecution agreement with the Commission in December 2010. The agreement did not require an admission of liability although the company did agree not to deny the underlying conduct except in proceedings not involving the SEC. The company also agreed to fully cooperate with the SEC’s inquiry.

The SEC’s second non-prosecution agreement involved an executive at AXA Rosenberg, an investment adviser which settled an administrative proceeding. In the Matter of AXA Rosnberg Group, Adm. Proc. File No. 3-14224 (Feb. 3, 2011). The case there involved a computer modeling error that resulted in significant losses. In June 2009 senior management discovered the error. Shortly thereafter it was corrected for U.S. clients and later for others. The firm did not disclose the error to clients who were registering complaints. Eventually, it was disclosed to the Commission and investors. The company settled the proceeding with a cease and desist order, payments for the harm caused investors and a penalty and the implementation of certain procedures.

The executive who entered into a non-prosecution agreement had a limited role in the misconduct and had advocated internally at the company that it be disclosed earlier. He fully cooperated with the Commission from the time he was first contacts and before entering into an agreement with the agency. He was also retiring. Accordingly, there was little likelihood of a reoccurrence of the conduct by the executive and, as with the fraud at Carter’s, the wrongful conduct was limited in nature.

Deferred prosecution

The two deferred prosecution agreements reflect similar circumstances. The Commission’s first non-prosecution agreement was in an FCPA case with Tenaris S.A. There the company, a Luxembourg based international seller of steel pipe products and related services to the oil and gas industry, was alleged to have obtained confidential information through a local agent on the bidding process for certain contracts. The agent was paid a commission, portions of which went to state officials as bribes.

When Tenaris first learned of the actions by its subsidiary, the company self-reported and conducted an extensive investigation and analysis of the situation. It fully remediated the wrongful conduct.

The company resolved the possible charges with the DOJ by entering into a non-prosecution agreement and paying a $3.5 million criminal fine. It settled with the SEC by entering into a deferred prosecution agreement and agreeing to pay $5.4 million in disgorgement and prejudgment interest. Under the terms of the agreement the company will continue to cooperate with the Commission and implement certain remedial efforts.

The Commission’s second deferred prosecution agreement was with the Amish Help fund, an Ohio based non-profit corporation. The violations centered on the fact that the Fund, established to provide loans to members to further the Amish way of life, had not updated its prospectus in 15 years. The prospectus was used to sell investment contracts to fund the loans. Over its history the fund had 3,500 investors, over 1,200 borrowers and about $125 million in mortgage receivables. It had never had a default and no investor had suffered a realized loss.

When notified that it was in violation of state and federal securities laws, the Fund immediately cooperated, updated the prospectus, offered all existing investors the right of recession and took other remedial steps. Thus this action, like the one involving Tenaris, was predicated a limited situation where the wrongful conduct was fully remediated once discovered.

Each of the non-prosecution and deferred prosecution agreements entered into by the Commission to date have been consistent with the decision not to prosecute in the 2002 Seaboard Release, the Commission’s long standing initiative on cooperation. That Release centered on a limited financial fraud in a subsidiary where the company fully cooperated once the situation was identified. Similarly, the wrongful conduct in Carter’s, AXA, Tenaris and Amish Fund involved limited, contained wrongful conduct which was fully remediated. In each instance the company or the executive fully cooperated with the Commission and there were assurances that the wrongful conduct would not be replicated in the future.

Viewed in this context the new cooperation initiatives do not appear to have significantly expanded the circumstances under which the Commission will not insist on resolving the situation with a settled enforcement action. At the same time the new initiatives do give the agency additional options for resolving a case beyond simply settling an enforcement action as in the past. To fully assess the significance of the initiatives however, the other actions in which the Commission has acknowledged cooperation in settled actions must be carefully analyzed and assessed. Those cases will be analyzed in the second part of this article later this week.

Hurricane Sandy: The President suggested that those who want to aid the victims of this devastating storm contribute to the Red Cross. The link is here.