Enforcement Highlights

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.

Department of Justice Obtains Its Second Spoofing Conviction and Its Novel Cooperation Agreement.

On the heels of its successful prosecution of Michael Coscia for spoofing, the Department of Justice (“DOJ”) recently secured a guilty plea and cooperation agreement in another high-profile “spoofing” case. By way of background, spoofing is the illegal practice of placing trades on the bid or offer side of a market with the intent to cancel them before execution in order to manipulate prices for personal gain. On November 9, 2016, Londoner Navinder Singh Sarao pleaded guilty to two criminal charges after losing his battle against extradition from the UK. Despite being charged with 22 counts, including wire fraud, commodities fraud, and spoofing, Mr. Sarao pleaded guilty to just two counts—one count of wire fraud, 18 U.S.C. § 1343 (which carries a maximum of 20 years’ imprisonment and a fine of $250,000) and one count of spoofing, 7 U.S.C. § 6c(a)(5)(c) and 13(a)(2) (which carries a maximum of 10 years’ imprisonment). He also acknowledged unlawful gains of at least $12,871,587.26 in trading profit as a result of his criminal actions and has agreed to forfeit that sum as part of his sentence. In addition, he has agreed to cooperate with the government, as discussed in more detail below. Although Mr. Sarao’s stated advisory sentencing guideline range is 78 to 97 months imprisonment, the DOJ will very likely seek a downward departure pursuant to Guideline § 5K1.1 as a result of his cooperation.

Mr. Sarao pleaded guilty to the following scheme. From January 2009 until at least April 2014, Mr. Sarao fraudulently traded E-mini S&P 500 futures contracts (the “E-mini”) on the Chicago Mercantile Exchange (“CME”). During the relevant time period, Mr. Sarao placed thousands of orders to buy or sell futures contracts of the E-mini on one side of the market with the intent to not execute those orders at the times that he placed them. Thus, he intended to manipulate the impressions of supply and demand for E-minis so as to induce other market participants to react and either buy or sell E-mini futures in response to his deception. When the market reacted accordingly, Mr. Sarao would execute genuine orders to buy or sell E-Mini future contracts on the opposite side of the market so as to generate significant trading profits.

Mr. Sarao generated these spoof orders both manually and using automated programs. Manually, he used two techniques. In the first technique, he would place large spoof orders (2,000-Lot Spoof Orders) that he did not intend to execute on the opposite side of the market from his genuine orders to buy or sell, thereby inflating volume and, in turn, creating artificially high or low prices to his advantage. Mr. Sarao used this technique approximately 802 times and made at least $1,884,537.50 in profit as a result. His second manual technique involved placing hundreds of resting spoof orders one or two levels of price from the best bids or offers currently available on the market. Mr. Sarao thereby created a false sense of supply or demand and would then trade genuine orders on the opposite side of the market to take advantage of the artificially inflated or deflated price.

Mr. Sarao also used automated programs to further his scheme. He utilized a “dynamic layering technique” that generated a block of typically five “sell” orders that would appear in unison at different sequential price points above the then-current E-mini sell price. As the current sell price moved, Mr. Sarao’s five “sell” orders moved in concert to remain the same distance above the sell price as they originally began, which thus reduced the chance that his orders would be executed. He used this technique to artificially create market activity approximately 3,653 times between 2009 and 2014 and made at least $9,667,258.22 in profit as a result of trading on the opposite side of the market. Mr. Sarao also utilized a second automatic technique known as the “Back of the Queue” Function. This technique added one unit to a particular designated order to increase its size when another order from a market participant was entered at the same size and price point as Mr. Sarao’s order, thereby ensuring that his orders were always more expensive, bigger, and behind all the other more attractive orders that were available so that it would not be executed or purchased. This artificially inflated the volume and, in turn, the interest on one side of the market. Mr. Sarao activated this function approximately 758 times and fraudulently made at least $1,319,791.54 in profit as a result. In addition to his fraudulent and manipulative schemes, Mr. Sarao made materially false statements and misrepresentations to the Commodities Futures Trading Commission (“CFTC”), CME, and regulatory officials in the UK.

These are a few points of interest regarding this guilty plea:

The U.S. Attorney’s Office for the Northern District of Illinois, home of the Securities and Commodities Fraud Section that obtained Michael Coscia’s guilty verdict, was acknowledged by “Main Justice” for its assistance with the case. The efforts of DOJ Main Justice, in coordination with the Northern District’s Securities and Commodities Fraud Section and the CFTC, indicate the high level of importance that the federal government places on pursuing criminal manipulative trading cases, such as Sarao and Coscia.
Under the original indictment, the DOJ accused Mr. Sarao of reaping at least $40 million in profits as a result of these schemes. While the plea agreement required him to forfeit more than $12,000,000, on November 17, 2016, the CFTC announced in its parallel case that Mr. Sarao settled with the CFTC and agreed, among other relief, to pay $25,743,174.52 in monetary penalties and to submit to a permanent trading ban.
Despite having fought extradition for nearly 18 months, after he pleaded guilty, Mr. Sarao was released on bail and was permitted to return to London with an 11 p.m. to 4 a.m. curfew to continue his cooperation with the government. Such cooperation must be extraordinary for the DOJ to agree to his return to a foreign country immediately after it had obtained extradition and the guilty plea.

With its second successful prosecution of spoofing since it was formally criminalized by statute with the 2010 Dodd-Frank Act, the DOJ is clearly making deterrence of such techniques one of its primary goals. Of course it is yet to be seen what type of cooperation Mr. Sarao can provide, but his lawyer told the court at his guilty plea hearing that despite his severe Asperger’s Syndrome, he had extraordinary abilities of pattern recognition. Such statements indicate that Mr. Sarao may provide technical cooperation to the DOJ in multiple, ongoing investigations, as opposed to the more usual cooperation of informing on others. With Mr. Sarao’s conviction and the Coscia appeal pending, DOJ’s ongoing efforts in this space are currently not public; however, Mr. Sarao’s cooperation may accelerate these pending investigations. With the DOJ’s and CFTC’s strong commitments to cracking down on spoofing and manipulative trading, we can expect that more DOJ and CFTC cases will be forthcoming.

The criminal case is United States v. Sarao, Case No. 15-cr-00075 (N.D. Ill.). The civil case is United States Commodity Futures Trading Commission v. Sarao, Case No. 15-cv-03398 (N.D. Ill.).

The SEC’s First Risk Alert of Fiscal Year 2017 Targets Registrant Rule 21F-17 Compliance

The Securities and Exchange Commission (SEC or Commission) Office of Compliance Inspections and Examination (OCIE) issued a Risk Alert on October 24, 2016, titled “Examining Whistleblower Rule Compliance.” This recent Risk Alert continues the SEC’s aggressive efforts to compel Rule 21F-17 compliance and puts the investment management and broker-dealer industries on formal notice that OCIE intends to scrutinize registrants’ compliance with the whistleblower provisions of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank). By way of background, Dodd–Frank established a whistleblower protection program to encourage individuals to report possible violations of securities laws. Importantly, in addition to providing whistleblowers with financial incentives, Rule 21F-17 provides that no person may take action to impede a whistleblower from communicating directly with the SEC about potential securities law violations, including by enforcing or threatening to enforce a severance agreement or a confidentiality agreement related to such communications. As discussed in our prior publications, the SEC’s Division of Enforcement (Enforcement) has instituted several settled actions against public companies for violating the “chilling effect” provisions of Rule 21F-17. During the past two months, the SEC has filed two additional settled enforcement actions, as summarized below. Thus, as the SEC embarks on the start of its 2017 fiscal year (FY2017), Rule 21F-17 remains an agency-wide priority, and issuers, investment management firms, and broker-dealers—if they have not done so already—need to take heed and proactively remediate any vulnerabilities that they may have regarding their Rule 21F-17 compliance.

OCIE Alerts Registrants

As described previously, the SEC’s most recent annual report stated that assessing confidentiality terms and language for compliance with Rule 21F-17 was a top priority for fiscal year 2016 and that staff had started the practice of examining company documents for such compliance. Now, less than one month into FY2017, OCIE has formalized this practice and notified the registrant community accordingly.

The Risk Alert spells out how OCIE plans to examine documents for these compliance issues. First, OCIE staff will examine whether any terms that are contained in company documents “(a) purport to limit the types of information that an employee may convey to the Commission or other authorities; and (b) require departing employees to waive their rights to any individual monetary recovery in connection with reporting information to the government.” Second, regarding the books and records to be examined, staff will analyze the following types of documents: compliance manuals; codes of ethics; employment agreements; and severance agreements. Finally, the Risk Alert identifies provisions that may contribute to violations of Rule 21F-17 or may impede employees or former employees from communicating with the Commission, such as provisions that:

require an employee to represent that he or she has not assisted in any investigation involving the registrant;
prohibit any and all disclosures of confidential information, without any exception for voluntary communications with the Commission concerning possible securities laws violations;
require an employee to notify and/or obtain consent from the registrant prior to disclosing confidential information, without any exception for voluntary communications with the Commission concerning possible securities laws violations; or
purport to permit disclosures of confidential information only as required by law, without any exception for voluntary communications with the Commission concerning possible securities laws violations.

Enforcement Update

Since August 16, 2016, the SEC has instituted two additional enforcement actions for violations of Rule 21F-17 based on prohibitions contained in severance agreements. First, in the Health Net, Inc., matter, the relevant violations involved release language in severance agreements that required employees to waive their right to any monetary recovery resulting from participating in a whistleblower program, among other issues. As part of the settlement, Health Net agreed to pay a $340,000 civil penalty and to engage in undertakings similar to those in the prior Rule 21F-17 cases. A review of the SEC’s Rule 21F-17 stand-alone cases reveals that the penalties have increased with each matter and that Health Net payed the largest fine to date. More recently, and within a month of OCIE’s Risk Alert, an international beverage conglomerate agreed to pay a civil penalty for violations of Rule 21F-17, among other charges. The Rule 21F-17 violations were related to a liquidated damages provision in the company’s separation agreement that did in fact cause an employee to stop communicating with the SEC until he received a subpoena. In this case, the primary charges involved books and records violations and internal control infractions that arose under the terms of the Foreign Corrupt Practices Act of 1977. Consistent with one other Rule 21F-17 case, the SEC appears to routinely investigate possible Rule 21F-17 violations while investigating other charges.

Takeaways

OCIE’s first Risk Alert of FY2017 puts the investment management and broker-dealer industries on notice that OCIE staff will examine and scrutinizing company documents for Rule 21F-17 compliance. More importantly and not stated in the Risk Alert—when coupled with Enforcement’s ongoing and aggressive interest—this combination indicates that OCIE staff will be looking to refer violations of Rule 21F-17 to their receptive Enforcement colleagues. Thus, investment management and broker-dealer registrants need to be proactive in assessing their risks and in reviewing all agreements, policies and procedures that may create exposure to SEC Rule 21F-17 violations. If there are any potential violations, Registrants should then execute a remediation plan. Cleary, this Risk Alert serves as a “notice,” and registrants who fail to act will likely be subjected to an OCIE referral to Enforcement.

The Supreme Court Appears Poised to Reaffirm Dirks v. SEC and Maintain Current Insider Trading Rules

For the first time in two decades, the Supreme Court heard oral argument in a case that could change the landscape for the government’s pursuit of insider trading violations. In Salman v. United States (Dkt. No. 15-628), the Court reviewed the government’s burden of proof when it prosecutes for insider trading. Specifically, the primary issue involves whether Salman’s “tipper” had received the kind of “personal benefit” required by precedent to hold Salman criminally liable for insider trading. The United States Court of Appeals for the Ninth Circuit affirmed Salman’s conviction. However, just two years ago, the United States Court of Appeals for the Second Circuit overturned the convictions of several insider traders because the government failed to establish that the insiders had received “a potential gain of a pecuniary or similar valuable nature.” In other words, the Second Circuit rejected governmental theories where insider tips were given to friends or even family members without any monetary gain to the insider. Thus, the Court’s ruling in Salman will also settle a current split between the Second and Ninth Circuits.

By way of background, for tipper–tippee cases, courts have determined that it is a crime for an insider with a duty of confidentiality (otherwise known as a tipper) to intentionally or recklessly provide confidential information (otherwise known as a tip) to another (otherwise known as the tippee) and to receive a personal benefit, directly or indirectly, from such action. The tippee, to be criminally liable, must also know about the confidential nature of the information (which has been breached) and the benefit the insider received. The Court specified much of these requirements in Dirks v. SEC, 463 U.S. 646 (1983), where it also stated “absent some personal gain, there has been no breach of duty to stockholders.”

How is personal gain defined? This is the main question the Court must decide in Salman, thereby resolving the federal circuit split. In Salman, the Court seemed both unwilling to take steps away from its prior precedent and suspect of the additional sweeping arguments made by the petitioner and the government. During the petitioner’s argument, Salman’s attorney contended that a line needed to be drawn as to what constituted a personal benefit. She suggested that the Court require the benefit to be tangible—not necessarily monetary or personal—but tangible. Justice Breyer, however, countered that helping “a close family member is like helping yourself.” Justice Kennedy clarified that in the law of gifts “we don’t generally talk about benefit to the donor” but that giving to a family member “ennobles you.”

The Justices’ statements appeared to indicate that they seemed more comfortable agreeing with the government, that insider information packaged as gifts to close friends or family crossed the line into creating or manifesting personal gain for the tipper, consistent with precedent. But they appeared unwilling to go further than that, despite the government’s urging that insider trading occurs whenever the insider provides confidential information for the purpose of obtaining a personal advantage for somebody else, regardless of previous or future relationships between the tipper and tippee. The government seemed not to view the personal advantage as a gain or benefit as those words are used colloquially. Instead, the government contended that the access to and communication of the confidential information in breach of the duty of confidentiality is in and of itself “a personal gain,” “a gift with somebody else’s property.” This interpretation was met with skepticism by the Court and the government seemed to back away from its argument, stating instead that it would not seek to hold liable somebody who was “loose in their conversations but had no anticipation that there would be trading.”

Justice Alito commented disapprovingly that neither side’s argument was consistent with the Court’s precedent in Dirks. Indeed, the Court appeared worried that any outcome other than affirmance would require new lines to be drawn. Any change to the law, as a result of this case, would impact the Court’s own judicially created insider trading standard from Dirks. As Justice Kagan put it to the petitioner: “[y]ou’re asking us to cut back significantly from something that we said several decades ago, something that Congress has shown no indication that it’s unhappy with, . . . [when] the integrity of the markets are a very important thing for this country. And you’re asking us essentially to change the rules in a way that threatens that integrity.” By the end of the argument, the government basically summarized what seemed to many observers, the Court’s preference: “If the Court feels more comfortable given the facts of this case of reaffirming Dirks and saying that was the law in 1983, it remains the law today, that is completely fine with the government.”

In light of the arguments and interactions with the Justices, the Court seems most comfortable with reaffirming the standards established with Dirks. Thus, it appears that despite the ruling in Newman, Salman may have provided the Court with nothing more than an opportunity to affirm its long-standing precedent.

SEC Announces Record Number of Enforcement Actions Filed in FY 2016

On October 11, 2016, the SEC announced its enforcement results for fiscal year 2016, which ended on September 30th. Press Release No. 2016-212. In total, the SEC continued its trend of increased enforcement activity by filing 868 enforcement actions, a new single-year high, which included “a record 548 standalone or independent enforcement actions” and “judgments and orders totaling more than $4 billion in disgorgement and penalties.” In comparison, the SEC filed 807 enforcement actions (507 standalone or independent actions) in fiscal year 2015, and 755 enforcement actions (413 standalone or independent actions) in fiscal year 2014. Touting its recent successes, SEC Chair Mary Jo White announced in the press release that “[o]ver the last 3 years, we have changed the way we do business on the enforcement front by using new data analytics to uncover fraud, enhancing our ability to litigate tough cases, and expanding the playbook bringing novel and significant actions to better protect investors and our markets.”

This past fiscal year marked new highs for the SEC in the number of cases involving investment advisers or investment companies, as well as enforcement actions related to the Foreign Corrupt Practices Act. Other significant actions the SEC highlighted involved “combating financial fraud and enhancing issuer disclosure,” holding “attorneys, accountants and other gatekeepers accountable for failure to comply with professional standards,” “enhancing fairness among market participants,” “rooting out insider trading schemes,” “fighting market manipulation and microcap fraud,” “halting international and affinity-based investment frauds,” “policing the public finance markets,” and “cracking down on misconduct involving complex financial instruments.”

Under the whistleblower program, the SEC this past year awarded a record $57 million to 13 whistleblowers, brought the first standalone action for retaliation against a whistleblower, and charged multiple companies for Rule 21F-17 violations, which prohibits any action impeding an individual from communicating directly with Commission staff about possible securities laws violations.

In addition, the SEC announced victories in five federal jury or bench trials this year, including its first ever victory “against a municipality and one of its officers for violations of the federal securities laws.”

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.

Private Equity Fund Advisers Agree to Settle Charges of Improperly Disclosing Acceleration of Monitoring Fees and Improperly Supervising Expense Reimbursement Practices

In a recent action, the SEC demonstrated its continuing focus on private equity fund advisers’ fees. On August 23, 2016, Apollo Management V, LP, Apollo Management VI, LP, Apollo Management VII, LP, and Apollo Commodities Management, LP (collectively, “Apollo”), agreed to settle charges brought by the SEC for “misleading fund investors about fees and a loan agreement and failing to supervise a senior partner who charged personal expenses to the funds” in violation of Sections 206 and 203 of the Advisers Act. Press Release No. 2016-165.

According to the SEC Order, Apollo advises a number of private equity funds that own multiple portfolio companies. Like most private equity fund advisers, Apollo charges annual management fees and certain other fees to the limited partners in its private equity funds and charges monitoring fees to certain portfolio companies under separate monitoring agreements. Release No. 4493. Investors benefit from the monitoring fees in that a certain percentage of the monitoring fees are used to offset a portion of the annual management fees. The SEC found that the monitoring agreements allowed Apollo, upon the triggering of certain events, to terminate the agreement and accelerate the remaining years of the monitoring fees to be collected in a present value lump sum termination payment. Triggering events included the private sale or IPO of a portfolio company. The SEC found that the accelerated fees created a conflict of interest for the adviser and noted that while the accelerated monitoring fees reduced annual management fees paid by the funds, the accelerated payments reduced the portfolio companies’ value prior to their sale or IPO, thereby “reducing the amounts available for distribution to the” the funds’ investors. The SEC found that Apollo did not disclose to the limited partners “its practice of accelerating monitoring fees until after Apollo had taken accelerated fees.” Id.

In addition, the SEC found that in June 2008, the general partner of one of Apollo’s funds entered into a loan agreement between the fund and four parallel funds in which the parallel funds loaned an amount to fund equaling the carried interest due to the fund from the recapitalization of two portfolio companies owned by the parallel funds. Until the loan was extinguished, taxes owed by the general partner on the carried interest were deferred and the general partner was required to pay accrued interest to the parallel funds. While the parallel funds’ financial statements disclosed the interest, Apollo’s failure to disclose that the accrued interest would be allocated solely to the account of the general partner was determined to be materially misleading.

The SEC further found that a former Apollo senior partner, on two occasions, improperly charged personal expenses to Apollo-advised funds and the funds’ portfolio companies, and in some instances, fabricated information to conceal his conduct. Upon discovery of the partner’s conduct, Apollo orally reprimanded the partner but did not take any other remedial or disciplinary steps.

Finally, according to the SEC, Apollo also failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the undisclosed receipt of accelerated monitoring fees and failed to implement its policies and procedure concerning employees’ reimbursement of expenses.

Without admitting or denying the SEC’s findings, Apollo agreed to pay $40,254,552, consisting of a disgorgement of $37,527,000 and prejudgment interest of $2,727,552. In addition, the SEC assessed a $12.5 million civil penalty, stating that the penalty is not higher due to Apollo’s cooperation during the investigation and related enforcement action. The SEC reserved the right to increase the penalty should it be discovered that Apollo knowingly provided false or misleading information or materials to the staff during the course of its investigation.

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.