Category: Compliance and Supervision

Second Circuit Will Not Revisit Opinion Barring Testimony Compelled by Foreign Sovereigns

On Thursday, the United States Court of Appeals for the Second Circuit refused to revisit a July 2017 decision by a panel of that court in United States v. Allen, which held, among other things, that the Fifth Amendment prohibits the use of compelled testimony in U.S. criminal proceedings, even when the testimony was lawfully compelled by a foreign sovereign. Thursday’s Order is significant because it ensures that the Allen decision is the law of the Second Circuit, and the government’s only remaining option to challenge Allen is to petition the United States Supreme Court for review.

The circumstances in Allen arose in the wake of the well-publicized LIBOR rate manipulation scandal. Among many other prosecutions, the United States sought to prosecute two citizens of the United Kingdom – Anthony Allen and Anthony Conti. Allen and Conti worked in the London office of a European bank, and were responsible for the bank’s U.S. dollar LIBOR submissions. The United States indicted Allen and Conti for wire fraud, bank fraud, and related conspiracy charges for allegedly manipulating the bank’s LIBOR submissions in favor of the bank’s trading positions. Following a full trial, Allen and Conti were convicted.

Allen and Conti appealed their convictions – and for good reason. Before being indicted in the United States, both Allen and Conti gave testimony to the U.K. Financial Conduct Authority (“FCA”) in connection with a nearly identical LIBOR manipulation investigation. Allen and Conti’s testimony to the FCA was compelled under penalty of imprisonment, and there is no Fifth Amendment analogue in such proceedings that shields an individual from giving self-incriminating testimony. A separate target of the FCA’s LIBOR investigation was then allowed to review Allen and Conti’s compelled testimony. That target subsequently became a cooperating witness for the United States – giving statements to the FBI, and ultimately testifying as a government witness at Allen and Conti’s trial. In addition, the FBI agent who testified in the grand jury to secure Allen and Conti’s indictment relayed information that was provided to the government exclusively through the cooperating witness.

On appeal, the Second Circuit overturned Allen and Conti’s convictions, dismissed their indictments, and clarified the boundaries of the Fifth Amendment in the process. First, the court held that the Fifth Amendment’s prohibition on the use of compelled testimony applies even when a foreign sovereign has compelled the testimony (and even when the foreign sovereign has acted perfectly lawfully in doing so). Second, if the prosecution uses a witness who has had substantial exposure to a defendant’s compelled testimony, the prosecution must prove that the witness’s review of the compelled testimony did not shape, alter or affect the evidence used in the grand jury or at trial. Moreover, where a witness has materially altered his testimony after being substantially exposed to a defendant’s compelled testimony, the government must produce something more than a bare, generalized denial that the witness’ testimony was tainted by the compelled testimony.

With Allen now firmly cemented as the law of the Second Circuit, there is more reason than ever to believe that its holdings will impact not only investigations and prosecutions in the Second Circuit, but throughout the entire country.

While the facts of Allen involved criminal prosecution, it is likely that Allen will impact SEC investigations. First, the Fifth Amendment provides protection to individuals under investigation by the SEC in that the SEC cannot compel individuals to testify against their own interest. That protection is limited because the SEC, as a civil litigant, is usually entitled to an adverse inference when an individual asserts the privilege. However, if the SEC receives compelled testimony from the FCA, it would appear that under Allen that the SEC would be prevented from using the substantive testimony in any subsequent prosecution. Second, given how often the SEC staff coordinates with the criminal authorities, the SEC staff will have to be very careful about sharing the substance of foreign compelled testimony with witnesses that the criminal authorities may want to use in any parallel criminal prosecution.

SEC Announces Enforcement Division Cyber Specialty Unit

On September 25, 2017, the Securities and Exchange Commission announced the creation of an Enforcement Division “Cyber Unit” that will focus on cyber-related violative conduct. The timing of this is much more than coincidental; indeed it’s obvious. Just last week, SEC Chairman Jay Clayton disclosed: 1) a 2016 intrusion of the SEC’s EDGAR system due to a software vulnerability in the test filing component of the system, resulting in access to nonpublic information; and 2) the creation of a senior-level cybersecurity working group. Since the disclosure of the EDGAR breach, the financial press has reported that SEC Enforcement, the Secret Service, and the FBI have been investigating, and that Chairman Clayton asked the SEC’s Office of Inspector General to investigate. On September 26, 2017, Chairman Clayton appears before the Senate Committee on Banking, Housing, and Urban Affairs where he will provide testimony and likely be subject to intense questioning.

Returning to the SEC’s Cyber Unit, while not specifically described as such, it appears to be created in the mold of the other Enforcement Division Specialty Units. This new unit’s mandate includes targeting cyber-related violative conduct, such as: market manipulation schemes involving false information spread through electronic and social media; hacking to obtain material nonpublic information; misuse of distributed ledger technology; misconduct perpetrated via the dark web; intrusions into retail brokerage accounts; and cyber-related threats to trading platforms and other critical market infrastructure. Consistent with this being a new specialty unit, the “Chief” is a former Co-Chief of the SEC’s Market Abuse Specialty Unit. Thus, registrants can expect the Cyber Unit to evolve much as the SEC’s other specialty units have previously. Specifically, this unit will likely: develop and expand SEC internal cyber knowledge; seek to hire external cyber experts; and dedicate its efforts and resources to this specialty area. Consistent with the evolutions of the other specialty units, the Cyber Unit will likely pursue cases that the Enforcement Division generally and historically might not have pursued, such as non-fraud violations considered more technical in nature.

While it’s ironic that the SEC announced the Cyber Unit on the heels of its recent breach, issuers and registrants should take this opportunity to self-assess and implement plans to avoid the SEC’s Cyber Unit in the future. Among various strategies, actively monitoring and assessing the SEC’s cybersecurity guidance and, in particular, the Office of Compliance Inspections and Examinations Risk Alerts, and documenting this work will support arguments of reasonable and diligent efforts. For further and more detailed guidance, look to FINRA’s February 2015 Report on Cybersecurity Practices. While FINRA’s oversight is limited to its member broker-dealer firms, this 46-page report provides plain-language guidance that any company or firm may want to consider reviewing and implementing as appropriate.

D.C. Circuit Split on Constitutionality of SEC’s Administrative Judges

We previously blogged about the D.C. Circuit’s decision in Raymond J. Lucia Cos v. SEC, which rejected the petitioner’s constitutional challenges to the SEC’s use of administrative law judges that are not appointed by the President. Yesterday, the D.C. Circuit issued a two sentence per curiam order denying an en banc review by an equally divided court.

We noted that the panel’s original opinion was the first appellate ruling of its kind. Although the panel’s decision remains in effect because the full court did not rehear the case, the strength of that ruling is now severely undermined. As we previously reported, the Tenth Circuit has already disagreed with the D.C. Circuit’s panel and held that the SEC’s administrative law judges are subject to the Constitution’s Appointments Clause. Yesterday’s order likely sets the stage for a Supreme Court challenge.

SEC Names Co-Directors of Enforcement

Last week, the Securities and Exchange Commission (SEC) announced that Acting Enforcement Director Stephanie Avakian and former federal prosecutor Steven Peikin had been named Co-Directors of the Division of Enforcement. In making the announcement, SEC Chairman Jay Clayton advised:

There is no place for bad actors in our capital markets, particularly those that prey on investors and undermine confidence in our economy. Stephanie and Steve will aggressively police our capital markets and enforce our nation’s securities laws as Co-Directors of the Division of Enforcement. They have each demonstrated market knowledge, impeccable character, and commitment to public service, and I am confident their combined talents and experience will enable them to effectively lead the Division going forward.

Prior to being named Acting Director in December 2016, Ms. Avakian served as Enforcement’s Deputy Director since June 2014. Mr. Peikin joins the SEC for the first time from private practice. Prior to that, from 1996 to 2004, Mr. Peikin served as an Assistant U.S. Attorney in the Southern District of New York. He was Chief of the Office’s Securities and Commodities Fraud Task Force, where he supervised some of the nation’s highest profile prosecutions of accounting fraud, insider trading, market manipulation, and abuses in the foreign exchange market. As a prosecutor, Mr. Peikin also personally investigated and prosecuted a wide variety of securities, commodities, and other investment fraud schemes, as well as other crimes.

As Chairman Clayton continues to appoint the Division leadership at the SEC and establish his own agenda for the Commission as its new Chairman, these Co-Director appointments bear a strong resemblance to those of his predecessors, Chair Mary Jo White and Chair Mary Schapiro. First, in 2009, Chair Schapiro appointed a former federal prosecutor for the first time to lead the SEC’s Division of Enforcement. Second, in 2013, Chair White appointed another former federal prosecutor, Andrew Ceresney. In furtherance of the striking similarities, Chair White appointed Mr. Ceresney as a Co-Director with the then Acting Director. Mr. Ceresney eventually took over the Directorship on his own. Thus, while many forecasted that the new Commission may perhaps be friendlier to the industry, with these Co-Director appointments Chairman Clayton looks to be following the lead of his recent predecessors rather than breaking from them. Lastly, if the precedent of the only prior Co-Directorship is any indication, then at some point in the foreseeable future Mr. Peikin will be occupying the Director’s chair on his own, as Mr. Ceresney ultimately did.

Compliance and Legal Officer Guidelines to Prevent Non-Line Supervisory Liability

Chicago partner Jim Lundy and associate Carrie DeLange, members of Drinker Biddle’s SEC & Regulatory Enforcement Team, authored “Compliance and Legal Officer Guidelines to Prevent Non-Line Supervisory Liability” for the National Society of Compliance Professionals’ (NSCP) professional journal, Currents, March 2017 edition.

The article provides guidance and recommendations to compliance officers and in-house attorneys with investment management and broker-dealer firms regarding the legal background and recommended practices to avoid supervisory liability with respect to the violative conduct of business personnel. Specifically, the article examines the applicable statutes and rules, the controversial “Gutfreund Standard,” and the SEC’s more recent guidance from a Division of Trading and Markets “FAQ” and speeches. Jim and Carrie build on this information to provide recommendations for investment management and broker-dealer compliance and in-house personnel to manage satisfying their compliance obligations while dealing with the potentially problematic conduct of business personnel.

Read “Compliance and Legal Officer Guidelines to Prevent Non-Line Supervisory Liability.”

Broker Pays $2.5 Million Fine for Using Market Volatility to Hide Markups Yielding Unearned Commissions

Last week, Louis Capital Markets, L.P. (“LCM”) agreed to disgorge $2.5 million in settlement of charges that it charged false execution prices to its customers in order to generate secret commissions.

LCM executed orders to purchase and sell securities for its clients, without holding any securities in its own account and thus bore no market risk, i.e., riskless principal trades. It purported to generate profits by charging customers small commissions, typically between $0.01 and $0.03 per share. LCM, however, unbeknownst to customers, inflated those commissions, by embedding undisclosed markups and markdowns into reported execution prices. LCM provided those false execution prices—either lower sales prices or higher purchase prices than LCM actually obtained in the market—to its customers. Critically, LCM did not engage in this deceptive behavior for every trade, rather “LCM opportunistically added markups/markdowns to trades at times when customers were unlikely to detect them, for example, during periods of market volatility.” (Order ¶ 13.) By engaging in these acts, LCM “unlawfully obtained millions of dollars from its customers.” (Order at 2.)

Without admitting or denying the findings, LCM agreed disgorge $2.5 million and to cease-and-desist violating Section 15(c)(1), which prohibits fraudulent conduct by broker-dealers. The SEC noted that while the conduct would support a civil penalty, it considered LCM’s financial status and accepted LCM’s offer that did not include one. Interestingly, LCM’s customers were “primarily large foreign institutions and foreign banks,” demonstrating the SEC’s commitment to eradicate fraud regardless of sophistication of investors.

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.

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