Ninth Circuit: You Don’t Need to Report Securities Violations to the SEC to Be Protected by the Dodd-Frank Anti-Retaliation Provision

On March 8, 2017, a divided panel of the United States Court of Appeals for the Ninth Circuit held that the anti-retaliation provision of the Dodd-Frank Act protects individuals who make purely internal disclosures of alleged securities violations. The decision, Somers v. Digital Realty Trust, Inc., No. 15-17352 (9th Cir. March 8, 2017), aligns the Ninth Circuit with the Second Circuit, which reached the same result in Berman v. Neo@ogilvy, LLC, 801 F.3d 145 (2d Cir. 2015). These opinions stand in stark contrast to the position of the Fifth Circuit, which concluded in Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620 (5th Cir. 2013), that in order to enjoy the protection of the anti-retaliation provision an individual must report the alleged securities violation to the SEC. While the Ninth Circuit’s decision is the latest entry in this evolving circuit split, it is unlikely to be the last—the Third Circuit is considering this very issue.

The Dodd-Frank Act defines a “whistleblower” as “any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission, in a matter established by rule or regulation, by the Commission.” 15 U.S.C. § 78u-6(a)(6).

As even the Ninth Circuit acknowledged, the definition above describes only those who report information to the SEC. But the Ninth Circuit did not regard this as determinative of the issue. Instead, the court analyzed both the purpose of the Dodd-Frank Act and the scope of the activities specifically covered by the anti-retaliation provision to reach its ultimate conclusion. In particular, the anti-retaliation provision protects those who engage in lawful activities “in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002 . . . and any other law, rule, or regulation subject to the jurisdiction of the Commission.” 15 U.S.C. § 78u-6(h)(1)(A)(iii). The Ninth Circuit, like the Second Circuit, noted that Sarbanes-Oxley requires both accountants and lawyers to report internally before they report to the SEC. Thus, using the “whistleblower” definition from Section 78u-6(a)(6) for purposes of the anti-retaliation provision would provide almost no protection to such lawyers and accountants—they would be forced to report internally first, and could legally be subject to retaliation in the period between their mandatory internal reporting and the time they made the report to the SEC. The Ninth Circuit concluded that such an approach “would make little practical sense and undercut congressional intent.”

The Ninth Circuit also agreed with the Second Circuit that the SEC regulation promulgated to implement anti-retaliation provision is entitled to deference. That regulation, Exchange Act Rule 21F-2, 17 C.F.R. § 240.21F-2, makes clear that the anti-retaliation provision protects anyone who engages in activities protected by 15 U.S.C. § 78u-6(h)(1)(A), including those who make internal disclosures under Sarbanes-Oxley.

Continuing its trend in Court of Appeals cases on this issue, the SEC appeared and argued as amicus in favor of expansive coverage of the anti-retaliation provision.

The SEC Heightens Its Interest in Robo-Advisers

Over the last two weeks, the SEC has put robo-advisers on notice that they are on the staff’s radar. First, on February 23, 2017, the SEC’s Division of Investment Management, along with the SEC’s Office of Compliance, Inspections, and Examinations, issued a Guidance Update for robo-advisers. The term “robo-adviser” refers to registered automated investment advisers that provide investment advice that uses computer algorithms. Robo-advisers generally collect information about a client’s financial goals, income, assets, investment horizon, and risk tolerance by way of an online or electronic questionnaire. With limited human interaction, robo-advisers use this information to create and manage investment portfolios for clients. Robo-advisers are often more economical than traditional investment advisers. Robo-advisers, which began as an appeal to millennials, are now widely becoming popular with all age groups and types of investors.

The Guidance Update focused on in three unique areas of the investment relationship: (1) the substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers; (2) the obligation to obtain information from clients to support the robo-adviser’s duty to provide suitable advise; and (3) the adoption and implementation of effective compliance programs reasonable designed to address particular concerns relevant to providing automated advice.

This Guidance Update specifically encourages robo-advisers to keep clients well-informed with respect to their use of algorithms to manage client funds. Robo-advisers must be diligent in their disclosures to clients of the risks and limitations inherent in the use of algorithms to manage investments. For example, an algorithm may not address prolonged changes in market conditions and investors need to know that. The Guidance Update also reminds robo-advisers that because of the limited human interaction with the client, issues, like disclosures, would most likely be done online. As such, communications, including written disclosures, should be effective, not hidden or indecipherable. Finally, the Guidance Update highlighted that for robo-advisers, compliance with the Advisory Act of 1940 may require more written documentation than regular investment advisers must provide. For example, robo-advisers should consider documenting the development, testing, and backtesting of the algorithms, the process by which they collect client information, and the appropriate oversight of any third party that develops or owns the algorithm or software utilized by the robo-adviser.

In addition to the Guidance provided to robo-advisers, the SEC Office of Investor Education and Advocacy also issued an Investor Bulletin on the subject of robo-advisers to alert potential clients to specific areas when dealing with a robo-adviser would be different from a more traditional adviser. Such areas include (1) the minimized level of personal interaction a client would receive, e.g., do you ever speak to a human?; (2) the standard information a robo-adviser uses to formulate recommendations, e.g., are the robo-advisers asking all the pertinent questions in their questionnaires?; (3) the robo-adviser’s approach to investing, e.g., are the robo-advisers using pre-determined portfolios or can you customize your investments?; and (4) the fees and charges involved, e.g., could you be charged penalties or fees if you want to withdraw your investment?  Investors should consider using robo-advisers because of the economic advantages but must be aware of the differences inherent in this new 21st century version of the investment advisor.

The SEC requires robo-advisers to be registered and makes them subject to the same substantive and fiduciary obligations as traditional investment advisers. In addition to the Alert and the Guidance Update, the SEC staff also addressed robo-advisers at SEC Speaks on February 24, 2017. At the Office of Compliance Inspections and Examinations (“OCIE”) panel, the office’s senior leadership put the audience and industry on notice of OCIE’s “Electronic Investment Advice Initiative.” Specifically, OCIE advised that it will be dedicating staff and resources to prioritize examining robo-advisers for this SEC fiscal year. Due to OCIE applying a risk-based approach to its examination program, they will likely focus on robo-advisers with large platforms or business models that OCIE believes pose potential risks to investors. For robo-advisers to prepare, we recommend that firms review the February 23, 2017 Guidance Update and the Office of Investor Education and Advocacy Investor Bulletin described above to proactively plan to be in compliance with this guidance. This way, firms examined as part of the Electronic Investment Advice Initiative, can attempt to avoid significant deficiencies or enforcement referrals from OCIE’s increased scrutiny of robo-advisers.

Update: SCOTUS Will Consider Statute of Limitations on Disgorgement

We previously wrote about how the SEC urged the Supreme Court to grant certiorari in Kokesh v. SEC, and on Friday, January 13, the Court did just that. In an order without comment, the Court granted certiorari after both the petitioner and the SEC requested the Court’s review, albeit for different reasons. While the petitioner believes he should not be subject to disgorgement for ill-gotten gains that were obtained more than five years ago, the SEC wants the Court to bring clarity to the circuit split that has developed since the Eleventh Circuit’s decision in SEC v. Graham, which held that the five-year statute of limitations applies to disgorgement. As we previously noted, the SEC argued that Graham impedes its ability to achieve uniformity in the administration of securities laws.

We will continue to monitor developments in this case, which is sure to shape the timing of future SEC enforcement investigations and actions and the remedies it will seek.

Congresswoman Seeks to Add Accountability to SEC Regulations, Past and Future

Republican Congresswoman Ann Wagner has sponsored the SEC Regulatory Accountability Act, H.R. 78, which requires the U.S. Securities and Exchange Commission to engage in more rigorous cost–benefit analysis before it can move forward with new regulations. Congresswoman Wagner called the bill “common-sense legislation” that regulators should already engage in.

Specifically, the Act requires the SEC to identify the nature, source, and significance of the problem each proposed regulation is intended to address; to adopt a regulation only after a reasoned determination that the regulation’s benefits justify its cost; to identify and assess available alternatives to additional regulation (including the alternative of not regulating); and to ensure that regulation is accessible and easy to understand. Under the Act, cost–benefit analysis requires the SEC to consider the impact of any regulation on investor choice, securities’ market liquidity, and small businesses. Costs and benefits are “both qualitative and quantitative.”

The Act also mandates additional action if the SEC amends or adopts a “major rule” in terms of economic impact. See U.S.C. § 804(2). Such amendment or adoption of a major rule requires the SEC to state (1) the regulation’s purposes and intended consequences, (2) metrics for measuring the regulation’s economic impact, (3) the plan to be used to assess whether the regulation has achieved its stated purposes, and (4) any foreseeable unintended or negative consequences of the regulation.

The Act, however, does not apply only to future SEC regulation. It also requires the SEC to review its existing regulations and modify, streamline, expand, or repeal those regulations that are outmoded, ineffective, insufficient, or excessively burdensome. The review must be completed within one year of the date of the SEC Regulatory Accountability Act’s enactment and every five years thereafter.

Congress passed H.R. 78 on January 12, 2017, but a motion to reconsider was laid on the table and agreed to without objection that same day. The bill is part of the Republican regulatory reform and will make it more difficult for the SEC to promulgate regulation. It has been attacked as protecting Wall Street interests and undermining investor protections.

Republican lawmakers have proposed the legislation before but have never cleared the Senate.

Supreme Court Reaffirms Dirks and Tosses Prosecution a Win

In Salman v. United States, 580 U.S. __ (2016), the U.S. Supreme Court upheld Bassam Salman’s conviction, giving prosecutors a win on the first insider trading case to be heard by the Court in nearly two decades. The unanimous decision, written by Justice Samuel Alito, is short and to the point. The Court reaffirmed the continued validity of Dirks v. S.E.C., 463 U.S. 646 (1983), and determined that a tipper receives a personal benefit by providing insider information to a “trading relative or friend.”

In Dirks, the Court ruled that a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty by disclosing the information. The fiduciary duty is breached when the insider will personally benefit, directly or indirectly, from his disclosure. In Salman, the Supreme Court stated that the benefit did not have to be money, property, or something of tangible value, because “giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.”

This decision resolved a circuit split between the Ninth Circuit, which had affirmed Salman’s conviction, and the Second Circuit, which ruled in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), that prosecutors had to prove that insiders received monetary or some sort of valuable benefit in exchange for disclosing information in order to convict the tippee who had used said information. The Supreme Court found that “[t]o the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends, Newman 773 F.3d at 452, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.” Yet, the Supreme Court seemed careful to imply that some portions of Newman remain good law, such as the requirement that the tippee knows the insider received a personal benefit from providing the inside information.

Despite, or perhaps because of the brevity of the opinion, questions still remain about what exactly is a benefit to the tipper. Clearly, familial connections or close friendships between the tipper and the tippee mean that prosecutors do not have to prove a specific pecuniary benefit occurred for the tipper, but would the same hold true if the tippee was a neighbor? Or, as the Second Circuit opined in Newman, an acquaintance from church or business school? The Supreme Court dodged these questions and more by deciding Salman narrowly on the facts, a model of judicial restraint in the wake of far ranging decisions like McDonell v. United States that essentially rewrote how prosecutors handle corruption cases.

SEC Affirms Commitment to FCPA Enforcement Actions

Andrew J. Ceresney, Director of the Division of Enforcement, reaffirmed the SEC’s focus on FCPA enforcement actions at the International Conference on the Foreign Corrupt Practices Act. Mr. Ceresney’s speech focused on companies’ need to self-report violations.

Mr. Ceresney stated that the SEC uses “a carrot and stick approach to encouraging cooperation,” where self-reporting companies can receive reduced charges and deferred prosecution and non-prosecution agreements, while companies that do no self-report do not receive any reduction in penalties. Mr. Ceresney warned that “companies are gambling if they fail to self-report FCPA misconduct.”

Mr. Ceresney gave examples of how this policy has benefited companies recently. Mr. Ceresney highlighted the SEC’s decision not to bring charges against the Harris Corporation after it self-reported violations and mentioned to examples where the SEC entered into non-prosecution agreements as a result of self-reporting.

Mr. Cerseney stated that the SEC’s “actions have sent a clear message to the defense bar and the C-Suite that there are significant benefits to self-reporting [to] and cooperation with the SEC” and that he expects “the Division of Enforcement will continue in the future to reinforce this message and reward companies that self-report and cooperate.”

Mr. Cerseney also spoke about recent cases that highlight “the Enforcement’s Division’s renewed emphasis on individual liability in FCPA cases[,]” noting that seven actions in the past year involved individuals. Mr. Cerseney stated that “pursuing individual accountability is a critical part of deterrence and . . . the Division of Enforcement will continue to do everything we can to hold individuals accountable.”

Mr. Cerseney’s remarks demonstrate that the Division of Enforcement does not expect to change its recent focus on FCPA violations and individual liability as it transitions to the new administration.

EB-5 Program Proves to Be Fertile Ground for Securities Law Violations

The SEC has brought approximately 20 litigated or agreed enforcement actions since February 2013 that have involved securities offerings that were made in connection with the EB-5 Immigrant Investor Program (the “EB-5 Program”). These enforcement actions have primarily charged that EB-5 sponsors have engaged in some sort of offering fraud or that an EB-5 sponsor improperly acted as an unregistered broker-dealer in connection with the sale of securities. Not only is the SEC devoting enforcement resources to this area, but in 2016, the SEC’s Office of Compliance Inspections and Examinations also announced that it would allocate examination resources to a number of priorities, including private placements that involve the EB-5 Program.

The EB-5 Program. Congress created the EB-5 Program, which is sponsored by the U.S. Citizenship and Immigration Services (“USCIS”), in 1990 to stimulate the U.S. economy and to provide foreign investors with a potential path to US residency. To qualify to apply for residency under this program, a foreign investor is required to make a qualified capital investment in a new U.S. commercial enterprise or a business project designated by USCIS as a “regional center” that is designed to create or preserve at least 10 permanent, full-time jobs for U.S. workers. Although the designation of a business opportunity as a “regional center” does not mean that either USCIS or the SEC approved of the quality of the investments that are offered by the business, the majority of EB-5 investments are made through one of these approved regional centers.

However, making an investment in the EB-5 Program does not guarantee a path to residency. Upon investing, a foreign individual must petition for conditional lawful permanent residency. EB-5 Immigrant Investor Process. USCIS will review the petition on the basis of the evidence of investment, investment in a new commercial enterprise, management of the new commercial enterprise, job creation, and job preservation. Upon approval of the investor’s petition for conditional lawful permanent residency, the investor must file an Application to Register Permanent Residence or Adjust Status or an Application for Immigrant Visa and Alien Registration. If the petition is approved, the foreign investor may then petition for the conditions to be removed after two years. USCIS will review that petition on the basis of the evidence of investment, job creation, and job preservation. If approved, the investor may live and work in the United States as a lawful permanent resident.

A foreign individual who invests in a fraudulent securities offering may lose the opportunity to obtain legal residency (and her initial investment) if the investment does not result in the creation of any jobs. Therefore, the SEC and the USCIS are on high alert for these types of scams and, in an effort to stop these offerings, are cooperating to send the message that violators will be prosecuted.

Examples of Actions that Involved Offering Fraud. On April 14, 2016, the SEC filed one of the most significant enforcement actions to date. In a 52-count complaint filed in the U.S. District Court for the Southern District of Florida against a Vermont-based ski resort, its owners, and its related businesses (in addition to several relief defendants), the SEC alleged violations of the antifraud provisions of Section 17(a) of the Securities Act of 1933 (the “Securities Act”) and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (the “Exchange Act”), for control person liability pursuant to Section 20(a) of the Exchange Act, and for aiding and abetting. Press Release 2016-69. The complaint alleged that the individuals and entities were engaged in a “massive eight-year fraudulent scheme” that used the EB-5 program to attract more than 700 foreign investors to finance the development of a ski resort and a biomedical research facility. Compl. ¶ 1, SEC v. Quiros, No. 1:16-CV-21301.

Of the $350 million that the defendants raised, they misused more than $200 million. Although the investors were told that their investments would fund a specific project, their investments instead went to funding deficits in earlier projects “in Ponzi-like fashion.” Press Release 2016-69. According to the SEC, the owner of the resort used a significant portion of the misused investments to “(1) finance his purchase of the [Vermont] resort; (2) back a personal line of credit to pay his income taxes; (3) purchase a luxury condominium; (4) pay taxes of a company he owns; and (5) buy an unrelated resort.” Compl. ¶ 4, Quiros, No. 1:16-CV-21301.

The defendants’ several misrepresentations and material omissions prompted the SEC to ask for preliminary and permanent injunctions, financial penalties, and disgorgement of ill-gotten gains plus interest, along with conduct-based injunctive relief against the owner of the resort and the CEO of the resort, and an officer-and-director bar against the owner of the resort. There are other examples of these types of actions. See, e.g., Press Release 2016-105 (announcing “fraud charges and an asset freeze against a husband and wife accused of misusing two-thirds of the money they raised from investors for the purpose of building and operating a new cancer treatment center”), Lit. Release 23409 (announcing court order to freeze assets of individual and her company after she was accused of using money raised from investors to purchase a boat and luxury cars), and Lit. Release 23077 (announcing charges against individuals who “conduct[ed] an investment scheme to defraud foreign investors” by misappropriating funds that were raised for an ethanol production plant that was never built and never created jobs).

Example of Unregistered Broker-Dealer Violations. In June 2015, the SEC shifted its focus from fraud and filed an action against unregistered brokers that facilitated EB-5 investments. Press Release 2015-127. The SEC alleged that Ireeco, LLC, and its successor, Ireeco Limited, acted as unregistered brokers for more than 150 foreign investors. The two businesses solicited EB-5 investors through Ireeco, LLC’s Web site and told investors that they would be matched with a regional center on the basis of their immigration status and their investment preferences. In reality, the businesses were directing investors to a small handful of regional centers that paid the businesses a commission per investor. In total, they placed $79 million in investments in regional centers.

The SEC alleged that this conduct violated Section 15(a)(1) of the Exchange Act because neither Ireeco, LLC, nor Ireeco Limited was registered as a broker-dealer or was associated with a registered broker-dealer in these securities transactions. Without admitting or denying the SEC’s findings, the respondents agreed to cease and desist from committing or causing any further violations of Section 15(a), to be censured, and to additional administrative proceedings to determine whether disgorgement of ill-gotten gains and/or civil penalties would be appropriate based on their violations. Release No. 75268. On May 12, 2016, the SEC affirmed the ALJ’s order that Ireeco, LLC, pay disgorgement of $1,700,000 plus prejudgment interest and that Ireeco Limited pay disgorgement of $1,479,633.85 plus prejudgment interest. Release No. 77824.

The Ireeco, LLC, case is not an isolated one. See, e.g., Press Release 2015-274 (announcing series of enforcement actions against law firms and lawyers nationwide for offering EB-5 investments without being registered to act as brokers) and L.R. 23298 (announcing administrative proceedings in which respondents agreed to settle charges that they acted as unregistered brokers in the sale of securities).

These cases highlight the recurring issues that the SEC is focusing on in the EB-5 context. The SEC’s Office of Investor Education and Advocacy and USCIS jointly published an investor alert to help prevent more individuals from falling victim to exploitations of the EB-5 program. Given that securities violations in connection with EB-5 Program offerings are a priority for 2016, EB-5 sponsors, including regional centers, broker-dealers, and other securities issuers, should expect SEC enforcement proceedings in this area to remain prevalent.

Third Circuit Defined “Investment Adviser” In Sentencing Appeal

Everett C. Miller pleaded guilty to securities fraud after he sold more than $41 million in phony, unregistered promissory notes in his firm, Carr Miller Capital, LLC, that falsely promised high returns with no risk. As part of his plea, Miller and the government stipulated to what they considered to be an appropriate offense level under the United States Sentencing Guidelines (the “Guidelines”). At sentencing, however, the district court applied the four-level investment adviser enhancement provided for by the Guidelines for securities laws violations perpetrated by “investment advisers,” as that term is defined by the Investment Advisers Act of 1940, 15 U.S.C. § 80b-2(a)(11). See U.S.S.G. § 2B1.1(b)(19)(A)(iii). Due to the enhancement, Miller received a 120-month sentence.

On appeal, Miller challenged, among other things, the application of the investment adviser enhancement, arguing that he was not an “investment adviser” under the Investment Advisers Act. The Investment Adviser Act defines “investment adviser,” in part, as a person who “for compensation engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.” 15 U.S.C. § 80b-2(a)(11). Miller argued that he was not “in the business” of providing securities advice; he did not provide advice “for compensation”; and he was not a registered investment adviser.

The Third Circuit first ruled that Miller was in the business of providing securities advice. In so concluding, the Third Circuit looked to a 1987 SEC interpretive release (the “SEC Release”) that stated the SEC considers a person who “holds himself out as an investment adviser or as one who provides investment advice” to be in “in the business.” Applying that guidance, the Third Circuit found that Miller was in the business of providing securities advice because he held himself out as an investment adviser in personal meetings with investors and because he was associated with a registered investment adviser.

The Third Circuit also relied on the SEC Release to conclude that Miller provided the advice “for compensation.” The SEC Release defines compensation as “any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services rendered, commissions or some combination of the foregoing.” The Third Circuit found that the investors’ principal on the promissory notes “became Miller’s compensation—his ‘economic benefit’—when he comingled investors’ accounts and spent the money for his own purposes.”

Finally, the Third Circuit rejected Miller’s argument that he could not be considered an “investment adviser”  solely based upon his association with an investment adviser. The Third Circuit ruled that “[r]egistration is not necessary to be an ‘investment adviser’ under the Act” and thus “Miller was an ‘investment adviser’ under the Act, despite his failure to register as such.”

Given the facts of this case, and the interpretative guidance on which the Court relied, the decision does not come as a surprise.