As we await the impact of the Biden Administration on the direction of the SEC, we have been given a glimpse of what is to come in a speech last month by the newly confirmed commissioner, Caroline Crenshaw. Specifically, Commissioner Crenshaw’s speech focused on “individual culpability” and penalties in the SEC’s enforcement program. Strikingly, the Commissioner decried the SEC’s past stance on penalties: “It is clear to me that the Commission has historically placed too much emphasis on factors beyond the actual misconduct when imposing corporate penalties – including whether the corporation’s shareholders benefited from the misconduct, or whether they will be harmed by the assessment of a penalty. This approach is fundamentally flawed.” Commissioner Crenshaw then stated that she thinks the SEC should revisit its approach to corporate penalties. It remains to be seen how Crenshaw’s remarks will be observed at Enforcement with respect to corporate penalties, let alone the application of her observations about the focus on “factors beyond the actual misconduct” could also be extended to individuals who are similarly facing substantial penalties for factors beyond their misconduct.
Last week, the Southern District of New York dropped its prosecution of Richard Lee, a former portfolio manager at SAC Capital who, in 2013, entered a guilty plea to trading on material nonpublic information that he gained from corporate insiders. The court recently ruled that Mr. Lee’s guilty plea must be vacated to conform with the ruling in United States v. Newman, 773 F.3d 438, 450-51 (2d Cir. 2014), abrogated on other grounds by Salman v. United States, 137 S. Ct. 420 (2016). Newman held that a tippee who traded on material nonpublic information must have knowledge that the insider acted for personal benefit in disclosing the information. Thus, in 2017, Mr. Lee moved to withdraw his guilty plea on the grounds that (1) he was innocent; (2) had he known additional information, he would not have pleaded guilty; and (3) his guilty plea was insufficient in light of Newman. Rejecting the first two, the court agreed with Mr. Lee that his guilty plea was insufficient under Newman.
Concurrent to his 2013 guilty plea with the DOJ, Mr. Lee also reached an agreement with the SEC. SEC v. Lee, 13-CV-05185 (RMB) (S.D.N.Y.). On September 12, 2013, the Court in that matter entered a judgment against Lee, enjoining him from future violations of the securities laws, and ordered him to pay disgorgement of $130,144.91, prejudgment interest of $57,777.23, and a civil penalty of $130,144.91. Mr. Lee was also barred from associating with any broker, dealer, investment adviser, municipal securities dealer, municipal adviser, transfer agent, or nationally recognized statistical ratings agency.
Prosecutors filed the request to dismiss on the basis that the evidence is now 10 years old and that Mr. Lee settled with the SEC. More specifically, the prosecutors explained that dismissing the pending charges was “in the public interest,” considering that “(1) the amount of time that has passed since the trades at issue and the resulting difficulty in securing evidence related to elements of the charged offenses; and (2) the SEC’s judgment and bar against Lee.”
The SEC announced settlements with an auditing firm (the “Firm”) and one of its partners relating to violations of certain auditor independence rules involving nineteen audit engagements with fifteen SEC-registrant issuers.
More specifically, the SEC found the Firm and its partner violated the Commission’s and Public Company Accounting Oversight Board’s (“PCAOB”) auditor independence rules. The alleged conduct involved performing prohibited non-audit services, including exercising decision-making authority in the design and implementation of software relating to one of its issuer client’s financial reporting as well as engaging in management functions for the company. The partner was responsible for supervising the performance of the prohibited non-audit services. Additionally, the SEC charged additional PCAOB-rule violations for failing to notify the clients’ audit committees about the non-audit services. The SEC described these failures as “mischaracterized non-audit services” despite the services involving financial software “that were planned to be implemented in a subsequent audit period and providing feedback to management on those systems—areas outside the realm of audit work.” The partner was also charged with providing material, non-public information concerning an issuer to a software company without the issuer’s consent.
In a 9-0 opinion issued on Wednesday, February 21, in Digital Realty Trust v. Somers (2018), the Supreme Court resolved a circuit split by holding that Dodd-Frank’s anti-retaliation provision does not apply to an individual, like Somers, who reported a violation of the securities law internally at his company but did not report the violation to the SEC.
As we have previously written, this case came to the Supreme Court from the Ninth Circuit, affirming the District Court’s holding that Section 78u-6(h), Dodd-Frank’s anti-retaliation provision, did not necessitate reporting a potential violation to the SEC before gaining “whistleblower” status. Somers v. Digital Realty Trust Inc., 850 F.3d 1045 (9th Cir. 2016). The Fifth Circuit had previously come to the opposite holding. Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620 (5th Cir. 2013). The Supreme Court decided this circuit split and reversed the Ninth Circuit’s holding—taking a narrow view of the “whistleblower” definition and statutory construction.
Dodd-Frank defines a “whistleblower” as “any individual who provides . . . information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” 15 U.S.C. § 78u-6(a)(6) (emphasis added). Somers and the Solicitor General argued that the “whistleblower” definition applies only to Dodd-Frank’s monetary reward program for whistleblowers and does not apply to its anti-retaliation provision. Further, the SEC itself advanced this view in its Rules. See 17 C.F.R. § 240.21F-2. The rule, as well as interpretative guidance released in 2015, explained that there were two definitions of “whistleblower”: one for the reward program, which required reporting to the SEC, and one only for the anti-retaliation provision, as long as the information is provided “in a manner described in Section 21F(h)(1)(A) of the Exchange Act,” which includes internal reporting. See id.; SEC Rel. No. 34-75592. The Rule further qualified that “[t]he anti-retaliation protections apply whether or not you satisfy the requirements, procedures and conditions to qualify for an award.” 17 C.F.R. § 240.21F-2(b)(1)(iii).
The Supreme Court, however, found this argument to be at odds with the “plain” language of the statute and the purpose of this portion of Dodd-Frank—to encourage individuals to report violations to the SEC. The Supreme Court reasoned that the SEC Rule should not be accorded deference because “Congress has directly spoken” on this issue in its unambiguous language in Dodd-Frank, and concluded that the language in Dodd-Frank was explicit in its exclusive inclusion of only those individuals who report securities complaints to the SEC.
While the Supreme Court’s decision limits the scope of potential “whistleblowers” who could seek the protection of the Dodd-Frank anti-retaliation provision, the decision may have another, less positive, collateral consequence. When the SEC promulgated the whistleblower rules, it received dozens of comments suggesting that the SEC require employees to report internally before reporting potential violations to the SEC. The SEC rejected that approach, but attempted to encourage internal reporting by including as a factor in deciding the amount of an award whether the whistleblower first reported the potential violation internally. In light of the Supreme Court’s decision, it is more likely that employees will forego reporting any potential violations internally and instead go straight to the SEC so as to not only qualify for an award, but also to seek the protection of the anti-retaliation provision.
The Securities and Exchange Commission (SEC) recently announced two significant insider trading cases. These pronouncements serve as reminders that the new Commission under the Trump Administration, while pursuing its agenda, will continue to ensure that the financial industry is “playing by the rules.” In addition, these particular cases involve: the SEC using a remedy that it had not used before in this context; and the SEC continuing to investigate and bring cases that involve governmental “insider” information.
Regarding the SEC extending the use of a “tool” from its remedy arsenal to the insider trading area, last week the SEC entered into a settlement with a billion-dollar hedge fund and its founder, which included an undertaking for an independent compliance consultant. The novel extension of this remedy to an insider trading settlement prompted the Acting Enforcement Division Director to issue a statement. In addition to the typical insider trading settlement terms, this settlement included an undertaking for an on-site “Compliance Consultant” to monitor and review for any future potential violative conduct through 2022. The SEC describes this process as “onsite monitoring by an independent compliance consultant with access to their electronic communications and trading records.” The SEC historically seeks independent consultants and monitors in other types of cases, including matters involving public companies with material accounting and control weaknesses. More recently, however, regulators have expanded the use of this remedial undertaking. For example, this past year, the Commodity Futures Trading Commission extended the use of independent monitors to a manipulative trading settlement.
Various publications hailed this insider trading settlement as a victory for individuals facing insider trading investigations. However, that perspective may be short-sighted. The SEC’s use of this remedy may allow it to “lower the bar” for insider trading investigations knowing that it may be able to obtain settlements such as this which do not result in a suspension or bar. While the avoidance of the suspension or bar is of course paramount to individuals, an undertaking such as this involves an invasive-type relationship with a third party who – while “independent” – may have an allegiance to a regulator or a court. Further, the defendant/respondent firm almost always bears the full cost of the services provided by the consultant or monitor. It’s not a stretch to describe these costs as additional/hidden monetary penalties that over a period of years (through 2022 for this matter) may increase to hundreds of thousands of dollars or more. Thus, while this may be a positive result for the head of this hedge fund, it may be an unfortunate development for individuals and entities whom the SEC investigates in the future who – before this settlement – the SEC may not have considered charging.
Turning to another matter, the other day, the SEC charged a former government employee, turned political intelligence consultant with insider trading. The SEC has historically brought insider trading cases involving “inside” governmental information; however these cases are not as common as tipper-tippee or misappropriation cases involving individuals associated with firms or public companies. In the SEC’s release, the Acting Director of the Enforcement Division provided this message, “As alleged in our complaint, a federal employee breached his duty to protect confidential information by tipping a political consultant who then passed along those illegal tips.” She further warned, “There’s no place on Wall Street or in our government for such blatant misuse of highly confidential information.” Further indicating the aggressive approach to this governmental insider trading matter, in a parallel action, the U.S. Attorney’s Office for the Southern District of New York announced related criminal charges. Thus, as stated above, at the start of this new Commission under the Trump Administration, the SEC remains creative and aggressive in its pursuit of insider trading violations.
In the not too distant past, the ruling by the Second Circuit Court of Appeals in U.S. v. Newman indicated a possible chilling effect on the government’s pursuit of insider trading cases and the various creative and aggressive strategies that it had started to apply in the decade prior. Less than six months ago, however, the U.S. Supreme Court sided with prosecutors in Salman v. U.S. The resulting opinion returned us to the standard first espoused in Dirks v. SEC in 1983. The Dirks opinion has been subjected to various criticisms over the decades from all sides for vagueness, amongst other issues. One of the collateral results of this vagueness is that it has allowed for creative and aggressive investigative and prosecutorial tactics that the government uses to investigate and charge insider trading cases. The timing of these two SEC cases and the recent issuance of the Salman opinion may be more than coincidental – as we may be witnessing an SEC emboldened by this Supreme Court ruling.