Today, the U.S. Chamber of Congress issued its Report and Recommendations from its independent, bipartisan Commission on the Regulation of U.S. Capital Markets in the 21st Century. (full report and executive summary available at Citing the erosion of the competitive position of the U.S. capital markets and an antiquated regulatory structure, the 146 page Report provides six principal recommendations to better protect investors and promote capital formation in today’s environment of increased globalization. The six recommendations are as follows:

• Reform and modernize the federal government’s regulatory approach to financial markets and market participants.

• Give the Securities and Exchange Commission (SEC) the flexibility to address issues relating to the implementation of the Sarbanes-Oxley Act of 2002 (SOX) by making it part of the Securities Exchange Act of 1934.

• Convince public companies to stop issuing earnings guidance or, alternatively, move away from quarterly earnings guidance with one earnings per share (EPS) number to annual guidance with a range of EPS numbers.

• Call on domestic and international policy-makers to seriously consider proposals by others to address the significant risks faced by the public audit profession from catastrophic litigation, as well as the Commission’s suggestion that national audit firms be allowed to raise capital from private shareholders other than audit partners.

• Increase retirement savings plans by connecting all employers of 21 or more employees without any retirement plan to a financial institution that will offer a retirement arrangement to those employees.

• Encourage employers to sponsor retirement plans and enhance the portability of retirement accounts through the introduction of a simpler, consolidated 401(k)-type program.

The Report makes four key recommendations relating to SEC and DOJ enforcement actions:

1) That DOJ “reassess the circumstances under which vicarious criminal liability for corporations is appropriate and should provide additional guidance to corporations on the practice efforts they may undertake to avoid vicarious criminal liability.” The Report supports bringing criminal actions against individuals when appropriate.

2) In making a charging decision DOJ should not request the waiver of the attorney-client privilege and work product protection from business organizations. The Report concluded that the McNulty Memo, which revised federal standards on the prosecution of organizations specifically to address the question of privilege waivers, should be revised. The Report recommends that business organizations not be given cooperation credit for waiving the attorney-client privilege or work product protection.

3) DOJ should not base charging decisions on whether a corporation advances counsel fees to its executives. Essentially, the Report endorses the approach of the McNulty Memo on this point.

4) Congress should enact legislation establishing selective waiver of privilege so that business organizations can share privileged information or documents with the SEC, without making that material available to third parties. The production to the SEC would be subject to a confidentiality agreement.

Overall, these recommendations are constructive but, for the most part, do not go far enough. Standards of organizational liability are the key point to each of the four recommendations listed above. Since the Supreme Court’s seminal decision in New York Cent. & Hudson R.R. Co., 212 U.S. 481, 495 (1909), business organizations have been subject to vicarious liability for acts of their agents that confer virtually any benefit on the company. Indeed, it is the potential sweep of organizational liability that led to the drafting of the Holder Memo in 1999, a predecessor to the McNulty Memo. The Holder Memo and its successors were designed primarily to discuss principles of organizational liability, not the waiver of the attorney-client privilege. The 2001 Seaboard Release is the SEC’s equivalent to the Holder Memo, discussing primarily considerations of organizational liability.

While the McNulty Memo and Seaboard Release do in fact provide some guidance on the question of organizational liability, the Report is clearly correct in its recommendation. Organizational liability is still broad to the point of being almost open ended. Clearly, an open ended standard is inappropriate. Thus, while the Report is correct, it does not go far enough. Its recommendation to reassess organizational liability should also apply to SEC enforcement actions.


It is a little discussed fact that, the scope of liability is, in part, responsible for the waiver issues that are the subject of the other recommendations. Since business organizations face such broad liability DOJ and SEC prosecutors have extremely broad discretion in making charging decisions. In this context cooperation is often critical to limiting liability. The failure of either the McNulty Memo or the Seaboard Release to define cooperation while holding out the prospect of amnesty or reduced sanctions in exchange for cooperation forces organizations to guess at what is necessary to avoid an action. Stated differently, organizations have little choice except to take every possible step to be viewed as cooperative, including waiving privilege. Limiting organizational liability will help solve this difficulty.

The Report, however, is clearly correct when it concludes that the only real solution to the waiver problem is to amend the McNulty Memo and eliminate any cooperation credit for privilege waivers. The Memo already places significant restrictions on the ability of prosecutors to seek privilege waivers. At the same time, it offers the prospect of credit for waivers by the corporation without a formal government request. While these waivers may be labeled “voluntary” because the government did not request them, in fact they are the product of the expansive liability business organizations face and the lack of defined cooperation standards. The Report’s recommendation to eliminate cooperation credit, which was voiced earlier by SEC Commissioner Atkins, will eliminate the so called “culture of waiver.” Yet, the recommendation does not go far enough – it should also apply to SEC enforcement actions.

Unfortunately, the final litigation recommendation of the Report concerning selective waiver fails to recognize the realities of the litigation market place. In theory if there is no cooperation credit for waivers, selective waiver would seem to be a viable option because it would permit the organization to determine when to share privileged material with DOJ or SEC prosecutors while still protecting the material from disclosure to third persons. In practice, however, selective waiver would not protect the corporation’s privileged material from disclosure. Both the DOJ and the SEC have disclosure obligations and cannot ensure that the privileged material would not be disclosed, which could result in the dissemination of corporate privileged material. Accordingly, the Report’s selective waiver proposal, while having some surface appeal, is unworkable in reality.

In sum, the Report’s DOJ and SEC litigation recommendations are constructive but for the most part do not go far enough. Organizational liability should be reviewed and more narrowly defined not just in criminal cases but also SEC civil enforcement actions. Steps should be taken to preserve the attorney-client privilege and work product doctrines by eliminating privilege credit for waivers in both DOJ and SEC charging decisions. The Report’s recommendation on selective waiver is, however, unworkable and will only undercut the essence and purpose of the privilege.

SEC Enforcement Trends:  Hedge Funds
This year and continuing into the future we should see continued efforts to regulate hedge funds through enforcement actions.  Recently the regulatory spotlight has been on hedge funds.  The reason for the increased focus on hedge funds is clear:  they play an increasingly significant role in the capital markets.  As SEC Commissioner Atkins noted in his recent speech at the Ninth Annual Alternative Investment Roundup,  “Hedge funds have been in the regulatory spotlight.  With over $1.2 trillion in worldwide assets, the attention is understandable.”   Remarks on January 29, 2007  
Presently a number of agencies in Washington are studying hedge funds and assessing the need for regulation.  Although the SEC’s efforts to regulate the funds failed, it seems determined to continue if only through enforcement actions.  Last year in Goldstein v. SEC, 451 F. 3d 873 (D.C. Cir. 2006) the D.C. Circuit struck down an SEC rule requiring hedge fund advisers to register.  Although the agency chose not to appeal the ruling, SEC Chairman Cox later told Congress that hedge funds will not go unregulated noting that they “are not, should not be, and will not be unregulated.”   Testimony Concerning the Regulation of Hedge Funds, July 25, 2006 www.sec.gv/news/testimony/ts072506cc.htm.  Subsequently, the agency issued Proposed Rule 206(4)-8 which prohibits investment advisers from making false statements to investors and Proposed Rules 509 and 216 which limit private placements of securities that are exempt from the registration requirements of the securities laws (and, thus, SEC scrutiny) by  requiring accredited investors to have at lest $2.5 million in investments.  Comments on the proposed restrictions on private placements – limiting those who can invest in hedge funds – have been very negative to date. 

Regardless of whether more rules are passed concerning hedge funds, the SEC will no doubt continue to impact their operations with enforcement actions – a kind of regulation  through litigation – because the antifraud provisions of the federal securities laws continue to apply to the funds.  Two of the cases brought last year may suggest future enforcement efforts: 

  • SEC v. Langley Partners, L.P. et al., (D.D.C. March 14, 2006),  involved claims of insider trading and the sale of unregistered securities regarding 23 PIPE offerings.  The action was resolved with a consent decree in which the defendants agreed to the entry of a statutory injunction and the entry of an order requiring the payment of over $13 million in disgorgement, prejudgment interest and penalties by the fund.  Defendant Thorp consented to the payment of a penalty of over $2.3 million.
  • SEC v. Deephaven Capital Management, LLC. et al., (D.D.C. May 2, 2006), involved claims of insider trading relating to 19 PIPE offerings.  The company consented to a statutory injunction and the payment of over $5.5 million in disgorgement, prejudgment interest and penalties.  Defendant Lieberman consented to the payment of a penalty of $110,000.  

The SEC’s efforts in these areas are continuing.  At present a sweep of major Wall Street brokers is underway.  (see blog posting 2/15/07).  The focus of the sweep is to determine if brokerage houses are giving hedge funds advance information about orders of large traders such as mutual funds so that the hedge funds can use the information to trade at other brokerage houses.  If established this would be a very complex form of front running.    
On February 22, 2007, the President’s Working Group on Financial Markets issued its Principles and Guidelines Regarding Private Pools of Capital, which recommended that hedge funds not be further regulated at this time. Public interest in the funds is high however.  In February U.S. Fortress conducted the first IPO by a fund.  The share price opened up 89% on the first day of trading.   This kind of public interest along with the rapidly growing influence of the funds on the markets because of their size virtually ensures more regulation through enforcement actions, such as those cited above, and which may come out of the Wall Street sweep  currently underway.  Accordingly, for the remainder of this year and for the foreseeable future we should expect a series of enforcement efforts like the current sweep and the cases noted above relating to hedge funds.