Category: Compliance and Supervision

Third Circuit Clarifies Extraterritorial Reach of Federal Securities Laws

The Third Circuit recently clarified the extraterritorial limits of the federal securities laws, as the U.S. Supreme Court defined in Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010). See United States v. Georgiou, Nos. 10-4774, 11-4587, 12-2077, __ F.3d __, 2015 WL 241438 (3d Cir. Jan. 20, 2015). George Georgiou and his co-conspirators made zero-sum trades between brokerage accounts in Canada, the Bahamas, and Turks and Caicos to artificially inflate the value of four “target stocks” that were available for trade in the U.S. through two interdealer quotation systems, the OTC Bulletin Board (“OTCBB”) and the Pink Sheets. Id. at *1. Georgiou used the fraudulently inflated value of his ownership interest in the target stocks as collateral to obtain loans that he would never repay, ultimately costing his creditors and the other stockholders of the target stocks millions of dollars. Id. On appeal, Georgiou argued that his convictions could not stand because they were based on the extraterritorial application of the federal securities laws. Id.

In Morrison, the Supreme Court limited Rule 10(b)’s application to two types of transactions: “(1) transactions involving ‘the purchase or sale of a security listed on an American stock exchange,’ and (2) transactions involving ‘the purchase or sale of any other security in the United States.’” Georgiou, 2015 WL 241438, at *4 (quoting Morrison, 561 U.S. at 273). The Third Circuit determined that Georgiou’s transactions were not of the first type, even though some of the purchases were executed by market makers operating within the United States, because the SEC does not consider the OTCBB and the Pink Sheets to be securities exchanges. Id. at *4–5.

The Third Circuit held, however, that Georgiou’s transactions were of the second type because they involved “the purchase or sale of any other security in the United States.” Id. at *4. Whether a transaction is domestic, the court observed, does not depend on “‘the place where the deception originated, but [the place where] purchases and sales of securities’ occurred.” Id. at *5 (quoting Morrison, 561 U.S. at 266). A purchase or sale of securities occurs “when the parties incur irrevocable liability to carry out the transaction,” such as “the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money.” Id. at *5–6 (citations omitted) (internal quotation marks omitted). The Third Circuit held that at least one transaction in each of the target stocks involved the purchase or sale of a security in the United States because “all of the manipulative trades were ‘facilitate[d]’ by U.S.-based market makers, i.e., an American market maker bought the stock from the seller and sold it to the buyer.” Id. at *6. Accordingly, the court affirmed Georgiou’s conviction under Section 10(b).

The take away: would-be fraudsters who think they can escape federal securities laws by setting up shop outside the U.S. to manipulate domestic securities should think again.

UPDATE: Third Circuit Affirms Arbitrability of Dodd-Frank Retaliation Claim in Khazin v. TD Ameritrade Holding Corp., ___ F.3d ___, No. 14-1689, 2014 WL 6871393 (3d Cir. Dec. 8, 2014).

In March, we wrote about a ruling out of the District of New Jersey enforcing an arbitration provision contained in an employment agreement that pre-dated Dodd-Frank.  The court reasoned that to disregard a pre-Dodd-Frank arbitration provision “would fundamentally interfere with the parties’ contractual rights and would impair the predictability and stability of their earlier agreement.” Khazin v. TD Ameritrade Holding Corp., Civil Action No. 13-4149 (SDW)(MCA), 2014 U.S. Dist. LEXIS 31142 (D.N.J. Mar. 11, 2014). The court also emphasized the “strong federal policy in favor of the resolution of disputes through arbitration” and cited a number of other federal courts that have reached a similar result. Id.

The Third Circuit, though, declined to reach this issue. Instead, it determined that Khazin’s claim, which was brought under Dodd-Frank, was not subject to the Anti-Arbitration Provision at all. 2014 WL 6871393, at *2. Dodd-Frank’s Anti-Retaliation Provision states: “Predispute Arbitration Agreements.—No predispute arbitration agreement shall be valid or enforceable, if the agreement requires arbitration of a dispute arising under this section.” Although the Anti-Arbitration Provision was included in Dodd-Frank, it followed language that said, “Section 1514A(a) of title 18, United States Code [Sarbanes-Oxley], is amended ….” The Dodd-Frank retaliation cause of action, on the other hand, was added to the Securities Exchange Act of 1934 located at 15 U.S.C. § 78a et seq. The court explained, “[i]t would be nonsensical for the word ‘section’ in the Anti-Arbitration Provision to refer to Section 922 of the Act [the whistleblower protection section of Dodd-Frank] when Section 922 expressly places its constituent parts in separate “sections” of the Code.” 2014 WL 6871393, at *3 n.3.

In light of this interpretation, the court did not express any opinion on whether the district court properly determined that Dodd-Frank’s Anti-Arbitration Provision did not invalidate the arbitration clause in his pre-Dodd-Frank employment agreement.

SEC Releases 2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program

By all accounts, 2014 was a year of tremendous success for the SEC’s Dodd-Frank Whistleblower Program. According to its 2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program, the SEC paid nine whistleblower awards, including a record $30 million award to a single whistleblower. SEC’s 2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program. Sean X. McKessy, the Chief of the Office of the Whistleblower, told Congress that these awards exceeded the number of awards made “in all previous years combined.” In addition, the SEC brought its first enforcement action under the anti-retaliation provisions of the Dodd-Frank Act.

The Annual Report offers more than just numbers, however. Without disclosing whistleblower identities, the Annual Report provides a “profile” of award recipients. Notably, more than 40% of the individuals who received awards were current or former employees of the company about which they reported. In addition, 80% of the individuals had raised issues internally prior to submitting information to the SEC, but the company failed to “take steps or remedy” the misconduct. Other award recipients included the actual victims of the fraud, individuals who had a “personal relationship” with the perpetrator, and contractors and consultants that worked with the company about which the report was made.

The Annual Report also reflects an increase in the number of whistleblower complaints in general. Complaints related to “Corporate Disclosures and Financials (16.9%), Offering Fraud (16%), and Manipulation (15.5%)” were the most common categories; complaints relating to municipal securities and public pensions were the least common categories. Moreover, the Office of the Whistleblower received 3,620 tips in 2014 (almost 400 more than last year) and returned more than 2,731 phone calls—recall that in May 2011 a whistleblower hotline was established and Whistleblower Office attorneys aimed to return messages within 24 hours.

Two important observations come from our review of the Annual Report. First, growing public awareness of the Whistleblower Program and the increase in the number and amount of whistleblower awards will only lead more individuals to bring alleged violations to the SEC’s attention. Second, given the fact that 80% of whistleblowers had raised their concerns first internally and the fact that nearly one-fifth of all tips, complaints, and referrals relate to accounting issues, it is extremely important for companies to implement adequate policies and procedures to respond to internal reports and to provide training to supervisors on how to handle internal complaints.

Commissioner’s Concerns About Civil Penalties Temper SEC’s Release of FY14 Enforcement Results

On October 16, the SEC publicized its preliminary enforcement results for fiscal year 2014. In what it described as a “successful enforcement year,” the Commission brought a record 755 actions and obtained $4.16 billion in penalties and disgorgement. These 2014 figures translate to an average of $5.5 million per action, which is 11% higher than the penalties and disgorgement obtained per action in fiscal year 2013 and a whopping 30% upsurge from just two fiscal years ago. It is not a coincidence that these developments correspond neatly with the appointment of Mary Jo White as SEC Chair in 2013. In fact, Chair White has been candid from the outset of her tenure about the Commission’s intention, under her direction, to “make aggressive use of our existing penalty authority, recognizing that meaningful monetary penalties—whether against companies or individuals—play a very important role in a strong enforcement program.”

It would appear, however, that at least one high-ranking SEC official has become uneasy during this era of heightened civil penalties. Speaking at the Securities Enforcement Forum in Washington, D.C., just two days before these results were released, Commissioner Michael S. Piwowar openly questioned whether the manner in which the SEC now administers penalties might be encroaching upon due process protections. As Commissioner Piwower explained:

In recent months, I have become concerned by the increasing number of staff recommendations that have not been accompanied by analysis of the principal factors described in the 2006 penalty statement. If we were a publicly-traded company, then we would likely be subject to an investigation if we knowingly permitted a misleading statement to remain outstanding without corrective disclosure. More importantly, we will have not accorded appropriate due process if we fail to follow our own publicly-announced framework for monetary penalties.

. . .

Thus, for purposes of transparency, clarity, and, most importantly, due process, the Commission should be forthcoming as to the appropriate analytical framework for corporate penalties.

The “2006 penalty statement” referenced in Commissioner Piwowar’s speech represents the Commission’s most recent effort to provide the investing public with “the maximum possible degree of clarity, consistency, and predictability in explaining the way that its corporate penalty will be exercised.” While this pronouncement set forth nine factors that may be weighed, the appropriateness of a penalty reportedly hinges on two principal considerations: – (1) whether the company received a direct benefit as a result of the violation and (2) whether the penalty will recompense or further harm the injured shareholders. This latter consideration, in particular, is inherently controversial. As the SEC acknowledged in the 2006 Statement, the penalties it imposes on public companies are costs frequently endured by innocent shareholders who already have been harmed by the company’s purported misconduct. Hence, SEC penalties should not be perceived as adding further insult to the financially injured.

Based on Commissioner Piwowar’s comments, the SEC may be drifting away from these factors, even though it has published no further guidance explaining which factors might now be disfavored or what other considerations could apply. If so, these recent developments cast a renewed spotlight on comments that Chair White made regarding the SEC’s 2006 Statement during a September 2013 speech to the Council of Institutional Investors. Most notably, Chair White stated:

While it is not a binding policy, the 2006 press release in my view sets forth a useful, non-exclusive list of factors that may guide a Commissioner’s consideration of corporate penalties, such as the egregiousness of the misconduct, how widespread it was, and whether the company cooperated and had a strong compliance program. The enforcement staff still references these factors as well as other inputs when analyzing and proposing their own recommendations to the Commission.

Ultimately, however, each Commissioner has the discretion, within the limits of the Commission’s statutory authority, to reach his or her own judgment on whether a corporate penalty is appropriate and how high it should be.

Interestingly, Commissioner Piwowar’s comments seem to reflect a general apprehension, at least on his part, to exercising discretion that is limited only by statutory constraints when the factors and “other inputs” used to determine the appropriateness of such penalties have not been disclosed publicly. To remedy this perceived problem, Commissioner Piwowar advocated that any revision to the 2006 Statement should be made through an interpretative release that would be subject to a notice-and-comment process. In his view, “This approach will satisfy any due process concerns, allow all interested persons to express their comments on the proposed framework, and provide a stronger defense of our approach should it be challenged in the future.”

Absent such an administrative undertaking or an unexpected reversal of policy, it likely will be left to the judiciary whether to impose any additional limitations on future SEC penalties. If the United States Court of Appeals for the District of Columbia’s decision in Collins v. SEC, No. 12-1241 (D.C. Cir. Nov. 26, 2013), provides any foresight, courts may be receptive to tethering future penalties so that they reasonably align with prior outcomes under similar circumstances. In Collins, the appellant challenged the SEC’s imposition of a penalty on grounds that it was arbitrary and capricious and violated the Excessive Fines Clause under the Eighth Amendment. Id. at *6. While the penalty was upheld, the appellate court made clear that the Commission cannot be “oblivious to history and precedent” and that a penalty could be deemed “arbitrary and capricious” if “the sanction is out of line with the agency’s decisions in other cases.” Id. at *8 (quoting Friedman v. Sebelius, 686 F.3d 813, 827-28 (D.C. Cir. 2012)). It remains to be seen, of course, what circumstances could trigger such a decision, although additional appeals – and judicial insights – seem likely in fiscal year 2015, particularly if the financial stakes continue to rise. In the meantime, the SEC appears more focused on making history and precedent, in part through the imposition of larger civil penalties, than being closely guided by it.

Made for the U.S.A Only: Second Circuit Holds That the Dodd-Frank Act’s Antiretaliation Provision Applies Only Domestically

According to the SEC, in fiscal year 2013, foreign whistleblowers accounted for 404 of the 3,238 whistleblower reports received by the SEC (nearly 12%). Recently, the Second Circuit Court of Appeals may have significantly undermined incentives for foreign tipsters to report potential violations to the SEC.

On August 14, 2014, the Second Circuit held that the Dodd-Frank Act’s whistleblower antiretaliation provision (15 U.S.C. § 78u-6(h)(1)) does not apply “extraterritorially” and thus did not cover a foreign tipster’s allegation that he had been terminated for reporting potential Foreign Corrupt Practices Act (FCPA) violations to his employer. Liu v. Siemens AG, Docket No. 13-cv-4385 (2d Cir. Aug. 14, 2014). The antiretaliation provision of the Dodd-Frank Act, which gives employees easy access to U.S. district courts, prohibits employers from retaliating against whistleblowers employees who make certain protected disclosures. The provision incentivizes reporting and facilitates the SEC’s enforcement of securities law violations.

The plaintiff Liu, a citizen and resident of Taiwan, alleged that he was fired from a Siemens Chinese subsidiary after he reported potential FCPA violations and other misconduct to his superiors. None of the alleged events related to Liu’s firing occurred in the United States. Nevertheless, Liu filed suit in the United States District Court of the Southern District of New York claiming that Siemens had violated the antiretaliation provision of the Dodd-Frank Act.

The Second Circuit affirmed the District Court’s order dismissing the complaint with prejudice and held that the Dodd-Frank Act’s whistleblower antiretaliation provision does not apply “extraterritorially.” The Second Circuit reasoned that the Dodd-Frank Act, like any statute, is presumed, in the “absence of clear congressional intent to the contrary, to apply only domestically.” Id., slip op. at 2. And the Second Circuit found “absolutely nothing in the text of the [antiretaliation] provision … or in the legislative history of the Dodd-Frank Act, that suggests that Congress intended the antiretaliation provision to regulate relationships between foreign employers and their foreign employees working outside the United States.” Id. at 12.

Because the antiretaliation provision did not extent extraterritorially, the court found that it did not cover Liu’s allegations since all events related to his termination¾the alleged misconduct, Liu’s discovery of the misconduct, and Liu’s termination¾occurred outside the United States. As such, the District Court correctly dismissed Liu’s complaint. The Second Circuit’s decision will likely impact the willingness of potential whistleblowers outside the United States to report misconduct to the SEC. Moreover, the lack of protection afforded to foreign-based whistleblower may adversely effect on the SEC’s FCPA investigations which usually involve misconduct that occurs outside of the United States. There is nothing in the Second Circuit’s decision, however, to indicate that foreign-based whistleblowers are prohibited from receiving payment under the Dodd-Frank bounty program.

While the ruling clarifies the Dodd-Frank Act’s geographical reach, it did not resolve another outstanding issue, namely whether or not Dodd-Frank applies to reports made internally, as opposed to reports made directly to the SEC.

Quarterly Whistleblower Award Update

Since our last quarterly update, the SEC’s Office of the Whistleblower (“OWB”) has issued four denial orders and three award orders. Here are some lessons learned from this activity:

• The SEC Will Not Award Whistleblowers Who Provide Frivolous Information. The SEC determined that a claimant (who submitted “tips” relating to almost every single Notice of Covered Action”) was ineligible for awards because he/she “has knowingly and willfully made false, fictitious, or fraudulent statements and representations to the Commission over a course of years and continues to do so.” Under Rule 21F-8, persons are not eligible for an award if they “knowingly and willfully make any false, fictitious, or fraudulent statement or representation, or use any false writing or document knowing that it contains any false, fictitious, or fraudulent statement or entry with intent to mislead or otherwise hinder the Commission or another authority.” 17 C.F.R. § 240.21F-8(c)(7). The OWB found that a number of passages submitted by the claimant were patently false or fictitious and that the person had the requisite intent because of the (1) incredible nature of the statements, (2) continued submissions that lack any factual nexus to the overall actions, and (3) refusal to withdraw unsupported claims at the request of the OWB. (May 12, 2104.)

• The SEC Will Enforce the Time Frames Set Forth in the Statue. The OWB denied two awards because the claimants did not submit an award claim within the 90-day period established by Rule 21F-10(b). The claimants argued that OWB should waive the 90-day period due to extraordinary circumstances. See 17 C.F.R. § 240.21F-8(a). The OWB determined that neither a lack of awareness that the information that the whistleblower had shared would lead to a successful enforcement action nor the lack of awareness that the Commission posted Notices of Covered Actions on its website constitutes an extraordinary circumstance to waive the timing requirement. See SEC Release No. 72178 (May 16, 2014) and SEC Release No. 72659 (July 23, 2014).

• Whistleblowers are Not Eligible for an Award Unless the Information Leads to a Successful Enforcement Action. The OWB denied an award to a claimant because the provided information did not lead to a “successful enforcement by the Commission of a federal court or administrative action, as required by Rules 21F-3(a)(3) and 21F-4(c) of the Exchange Act.” OWB also noted that the claimant did not submit information in the form and manner required by Rules 21F-2(a)(2), 21F-8(a), and 21F-9(a) & (b) of the Exchange Act. See In the Matter of Harbinger Capital Partners, LLC, File No. 3-14928 (July 4, 2014).

• The OWB Can Be Persuaded to Change Its Preliminary Determination. Although the OWB initially denied the whistleblower’s award claim on the basis that the information did not appear to have been voluntarily submitted within Rule 21F-4(a)(ii) because it was submitted in response to a prior inquiry conducted bya self-regulatory organization (“SRO”). In a Final Determination issued on July 31, 2014, however, the OWB determined that claimant was entitled to more than $400,000. OWB noted that a submission is voluntary if it is provided before a request, inquiry, or demand for information by the SEC in connection with an investigation by the Public Company Accounting Oversight Board, any self-regulatory organization, Congress, the federal government, or any state Attorney General.

On the basis of the unique circumstances of this case, the OWB decided to waive the voluntary requirement of Rule 21F-4(a) for this claimant. The SEC noted that the claimant “worked aggressively … to bring the securities law violations to the attention of appropriate personnel,” the SRO inquiry originated from information that in part described claimant’s role, claimant believed that the company had provided the SRO with all the materials that claimant developed during his/her own internal efforts, and claimant promptly reporting to the SEC that the company’s internal efforts as a result of the SRO inquiry would not protect investors from future harm. Sean McKessy, chief of the SEC’s Office of the Whistleblower, remarked that “[t]he whistleblower did everything feasible to correct the issue internally. When it became apparent that the company would not address the issue, the whistleblower came to the SEC in a final effort to correct the fraud and prevent investors from being harmed. This award recognizes the significance of the information that the whistleblower provided us and the balanced efforts made by the whistleblower to protect investors and report the violation internally.” See SEC Release No. 72727 (July 31, 2014); SEC Press Release, “SEC Announces Award for Whistleblower Who Reported Fraud to SEC After Company Failed to Address Issue Internally,” (July 31, 2014).

• SEC Continues to Make Awards to Qualified Claimants. On June 3, 2014, the SEC awarded two claimants 15% each for a total of 30% percent of the monetary sanctions collected in the covered action. See SEC Release No. 72301 (June 3, 2014). On July 22, 2014, the SEC awarded three claimants 15%, 10%, and 5% respectively (for a total of 30%) of the monetary sanctions collected in the Covered Action. See SEC Release No. 72652 (July 22, 2014).

Profits Do Not Always Equal Disgorgement

Judge Scheindlin of the Southern District of New York recently rejected the SEC’s attempt to seek disgorgement of almost $500,000,000 from Samuel Wyly and Donald R. Miller Jr., the Independent Executor of the Will and Estate of Charles J. Wyly Jr. (collectively, “defendants”). According to the SEC, this amount represented the total profit that the defendants gained from their illegal conduct, which included securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Section 17(a) of the Securities Act of 1933 and failure to make certain disclosures in violation of Sections 13(d), 14(a), and 16(a) of the Securities Exchange Act of 1934.

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Director of SEC’s Division of Investment Management Provides Insights into Agency’s View of Alternative Mutual Funds and Focus of Upcoming Sweep Exam

On June 30, 2014, in remarks to the Practising Law Institute’s Private Equity Forum, Norm Champ, Director of the SEC’s Division of Investment Management, addressed the increase in the number of mutual funds that use alternative investment strategies and the potential risks that the Division of Investment Management has identified with those strategies. See SEC Press Release. Champ’s observations are particularly relevant in light of the Office of Compliance Inspections and Examination’s (“OCIE’s”) announcement that it will conduct a national sweep exam involving between fifteen and twenty alternative mutual funds beginning this summer and continuing into the fall. According to Champ, the exams are intended to produce valuable insight into how alternative mutual funds attempt to generate yield and how much risk they undertake, in addition to monitoring how boards are overseeing the funds’ operations. To that end, Champ said that the exams will focus on liquidity, leverage, and board oversight.

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