In U.S. v. Stringer, No. 06-30100 (April 4, 2008), the Ninth Circuit Court of Appeals vacated the dismissal of a criminal indictment. The district court had dismissed the case based on the misconduct of the U.S. Attorney’s Office (“USAO”) and the SEC. That court concluded that the USAO and SEC violated the constitutional rights of defendants by merging their investigations and concealing the criminal inquiry behind the SEC civil investigation which was used to collect evidence for the USAO. U.S. v. Stringer, 408 F. Supp. 2d 1083 (D. Or. 2006).

The Court of Appeals disagreed, concluding that “the government fully disclosed the possibility that information received in the course of the civil investigation could be used for criminal proceedings [by furnishing standard warnings on Form 1662]. There was no deceit; rather, at most, there was a government decision not to conduct the criminal investigation openly … and nothing in the government’s actual conduct of those investigations amounted to deceit or an affirmative misrepresentation justifying the rare sanction of dismissal … .”

The Court’s ruling is based on the following key factual findings.

• At the outset of its inquiry, the SEC notified the U.S. Attorney’s Office.

• Very early in the inquiries, the USAO identified two of its three targets and decided not to “surface,” as they called it, during the SEC investigation;

• The SEC and the USAO decided that it would “impede” the cooperation of the potential defendants with the SEC if the existence of the criminal investigation became known;

• The SEC, according to the Court of Appeals, “facilitated the criminal investigation in a number of ways. The SEC offered to conduct the interviews of defendants so as to create ‘the best possible record’ in support of ‘false statement cases’ against them, and the AUSA instructed the SEC Staff Attorney on how best to do that. The AUSA asked the relevant SEC office, located in Los Angeles, to take the depositions in Oregon so that the Portland Office of the USAO would have venue over any false statements cases that might arise from the depositions, and the SEC did so.”

• During the testimony of Mr. Stringer, his counsel asked the SEC about any involvement by the USAO – they SEC cited Form 1662.

• About one year before any criminal indictment, the SEC settled with two defendants

Since the SEC did not make any affirmative misrepresentation and furnished standard Form 1662, which notes that a criminal reference may be made, the Court concluded that the government’s conduct did not violate the defendants’ constitutional rights.

What the Court did not discuss is the fact that both the SEC and USAO carefully implemented a plan to obtain evidence and a settlement they might not have otherwise obtained and to increase the potential criminal charges. The facts detailed by the Court of Appeals make it clear that the SEC and DOJ carefully planned and merged their joint investigations to make sure that the defendants continued to cooperate with the SEC. Both the SEC and USAO believed that if the criminal investigation “surfaced,” that is became know to the defendants, that fact would impede cooperation. Stated differently, if the defendants knew about the criminal investigation, they would invoke their constitutional right not to testify and might not settle in the view of the SEC and USAO.

By not disclosing that the criminal investigation was on-going, that the defendants were targets and that the SEC was a front for the criminal prosecutors, the SEC and USAO obtained what they could not otherwise obtain: witness statements; a settlement; and enhanced criminal charges to increase the probability that the government could win the criminal case.

The Supreme Court has long made it clear that the government cannot obtain indirectly what it is prohibited from obtaining directly. The Ninth Circuit, however, side-stepped this issue by relying on Form 1662, a multiple page document the SEC routinely hands out to all witnesses which states that there may be a criminal reference. That form should not be a substitute for truth and candor by government prosecutors – particularly where the admitted facts demonstrate that they planned to obtain by indirection what they could not obtain if they told the truth.

The USAO and the SEC won this case in the Court of Appeals. The Court accepted almost without question the arguments made in the SEC’s amicus brief about Form 1662. The irony is that while in Stringer the SEC and USAO crafted tactics to obtain testimony from the defendants, in the end that is precisely what they will lose. In view of Stringer and the increasing trend toward criminalization, prudent defense counsel in the future will have little choice but to advise witnesses to invoke their constitutional rights. This unfortunately will deprive the SEC of information it may need for its investigation while depriving witnesses of an opportunity to explain critical events.

More importantly however is the overall detrimental impact tactics such as those blessed by Stringer will have on law enforcement. The law cannot be enforced with the kind of tactics used here. The SEC is well aware of this. In corporate governance cases, it frequently talks about “tone at the top,” meaning that compliance, lawful conduct and ethical actions in the market place come from the top or those in charge. So too with law enforcement. Respect for the law begins with those who enforce it. If those who enforce the law do not act in good faith in accord with basic legal principles and follow the highest ethical standards, including a basic respect for the rights of citizens, they cannot effectively enforce it.

The USAO and the SEC won in Stringer. Before that win turns into a loss however, it is time for the SEC to revise its policies on criminal referrals. Form 1662 is simply not enough. If the SEC has made a criminal reference absent exigent circumstances there is no reason it cannot tell witnesses rather that relying on a standard form which effectively communicates nothing.

In the past week, critical issues regarding securities litigation and enforcement continued. The subprime crisis continued to dominate the news with regulatory reform being the topic of the day following Secretary Paulson’s speech (previously discussed here). There, the Secretary offered a blue print for regulatory reform which would essentially formalize the powers recently exercised by the Fed, merge the SEC and the CFTC in a fashion which would alter the former’s historic approach to regulation and oversight in favor of that used by the latter and federalize insurance regulation which is currently handed by the states. The Secretary’s proposals will no doubt be debated for a considerable period of time. Indeed, others in Congress are already racing to put out regulatory reform plans of their own.

At the same time the Financial Services Authority (“FSA”) in London continued its trend toward increasing regulation to cope with market manipulators and insider trading. Historically, the FSA has opted in favor of regulation rather than litigation with only a small fraction of its resources being dedicated to enforcement. While the FSA has been seeking to have powers similar to those of the SEC for years, now it appears that there will be a step forward: the FSA will be empowered to provide whistleblower protection to those who cooperate with a current market manipulation probe. While there is a debate in London as to effectiveness of such powers, at least for the moment the agency has been granted additional authority.

The options backdating scandal also continued to drag on, with perhaps a small step closer to the end. Texas-based HCC Insurance Holdings Inc received court approval of a settlement in a derivative suit based on option backdating. The only question now for the company as to option backdating is the SEC, which has an on-going inquiry. Of course, HCC is not alone in this regard since the SEC reportedly has about 80 inquiries open regarding backdated options.

Broadcom would also like to end its option backdating woes. The company is reportedly meeting with federal prosecutors in an effort to avoid criminal prosecution. Previously, former human resources executive Nancy Tullos settled option backdating claims with the SEC. SEC v. Tullos, Civil Action No. SACV 08-242 AG (C.D. CA. March 4, 2008) (discussed here). In that settlement Ms. Tullos consented to the entry of an injunction prohibiting future violations of Securities Act Section 17(a)(3) and the books and records provision of the Exchange Act. In addition she agreed to pay a $100,000 civil penalty. Last year Ms. Tullos pled guilty to one count of obstruction of justice in exchange for her cooperation (discussed previously here).

Finally, the GAO issued a follow up letter to its November 2007 report which concluded the SEC has weak internal controls. The letter contains 14 recommendations to the SEC for improvement of its controls. Letter from Jeanette M. Granzel, Director Financial Management and Assurance, GAO to The Honorable Christopher Cox, Chairman, SEC, dated April 1, 2008.

The new GAO report has, of course, a strange irony in view of the agency’s role in enforcing internal control provisions on corporate America. At the same time it is not the first call for a reform of SEC procedures.

Over the last year the SEC has received repeated calls to improve its transparency and reform its enforcement policies. For example, earlier this year the Senate Committee investigating the botched Pequot Capital investigation issued a report which was sharply critical of the agency. Its recommendations included a call for the Enforcement division to adopt formalized procedures for handling its cases. Minority Staff of S. Comm. On Finance, 110th Cong., 1st Sess., “The Firing of an SEC Attorney and the Investigation of Pequot Capital Management” at 45 (S. Prt. 110 –28 Aug. 2007). SEC Commissioner Atkins made a similar recommendation earlier this year at the SEC Speaks in 2008 Program of PLI.

Other recommendations for reform include a call for a new Wells Committee on settlement procedures, a recommendation that open file settlement procedures be used and that cooperation standards be revised. See, e.g., Remarks at the Federalist Society Lawyer’s Chapter of Dallas, Texas ( Jan. 18, 2008). The ABA and others have joined in the call for a reform of cooperation policies in the wake of court cases and congressional testimony noting that DOJ and SEC practices had created a “culture of waiver.” See, e.g., Survey by former Delaware Supreme Court Justice Norman Veasey in response to a congressional request.

To date most requests for reform have gone largely unheeded. Perhaps, the GAO will fare better with its suggestions.