Enforcement Highlights

First Circuit Quietly Joins the “Personal Benefit” Fray

The First Circuit recently added to the increasingly ambiguous personal benefit requirement, finding that an alleged friendship and promises for free “wine, steak, and visits to a massage parlor” were enough to support a misappropriation theory of liability for insider trading. United States v. Parigian, — F.3d —, No. 15-1994, 2016 WL 3027702, at *2 (1st Cir. May 26, 2016). As highlighted in previous posts, the Second and Ninth Circuits have interpreted the personal benefit requirement differently, and in January, the Supreme Court granted certiorari to review the issue.

Parigian pleaded guilty to criminal securities fraud on the condition that he could appeal the denial of his motion to dismiss the superseding indictment for failing to allege a crime. Id. at *1. The indictment alleged that Parigian’s golfing buddy, Eric McPhail, provided nonpublic information to Parigian that McPhail had received from a corporate insider. Id. at *1–2. McPhail was not alleged to have engaged in any trading himself; instead, he was compensated for the information “with wine, steak, and visits to a massage parlor.” Id. at *2. Parigian argued the indictment failed to properly allege a “misappropriation” theory of liability for insider trading because, among other things, there was no personal benefit to McPhail. Id. at *3.

In Dirks v. SEC, 463 U.S. 646, 662 (1983), the Supreme Court ruled that the tippee in a traditional insider trading scheme cannot be held liable unless the insider “will benefit, directly or indirectly, from his disclosure.” The First Circuit has, by its own admission, “dodged the question” of whether “such a benefit need be proven in a misappropriation.” Parigian, 2016 WL 3027702, at *7. Instead, the First Circuit has twice considered the issue and determined that it was satisfied, if required, under the facts of those cases. Id. It was satisfied, the court said, because in one case the misappropriator and tippee were “business and social friends with reciprocal interests” and in the other case because “the mere giving of a gift to a relative or friend is . . . sufficient.” Id.

Although the court acknowledged the more recent decisions of the Second Circuit and the Ninth Circuit, the former holding that objective proof of a potential pecuniary gain is necessary and the latter holding that evidence of a close personal relationship is enough, the court refused to stray from its own precedent. Id. at *8. Under that precedent, the indictment adequately alleged a personal benefit because of the “friendship between McPhail and Parigian plus an expectation that the tippees would treat McPhail to a golf outing and assorted luxury entertainment.” Id.

Further clarity will have to wait for the Supreme Court’s decision next term.

Update: Eleventh Circuit Affirms Dismissal of Claims for Declaratory Relief and Disgorgement in SEC v. Graham, F.3d , No. 14-13562, 2016 WL 3033605 (11th Cir. May 26, 2016)

We previously wrote about a decision out of the U.S. District Court for the Southern District of Florida in SEC v. Graham, 21 F. Supp. 3d 1300 (S.D. Fla. 2014), which involved claims by the SEC in connection with an alleged $300 million real estate Ponzi scheme. Echoing the Supreme Court’s reaffirmation in SEC v. Gabelli, 133 S. Ct. 1216 (2013), of the importance of statutes of limitation “to the welfare of society,” the district court had held that the five-year statute of limitations in 28 U.S.C. § 2462 is jurisdictional rather than a “claim-processing rule” and that the limitations period provided by § 2462 applies not only to civil penalties but also to equitable relief including injunctions, declaratory relief, and disgorgement. On May 26, 2016, the Eleventh Circuit affirmed in part, reversed in part, and remanded this decision for further proceedings.

The Eleventh Circuit disagreed with the district court’s characterization of injunctive relief as “nothing short of a penalty” and therefore subject to the § 2462 time limit on actions “for the enforcement of any civil fine, penalty, or forfeiture.” Noting that it was bound by its previous holding that “[t]he plain language of section 2462 does not apply to equitable remedies,” United States v. Banks, 115 F.3d 916, 919 (11th Cir. 1997), the court additionally explained that injunctions are not “penalties” because they are forward-looking rather than backward-looking relief.

Nevertheless, the court affirmed dismissal of the SEC’s claims for declaratory relief and disgorgement. The court reasoned that unlike injunctive relief, declaratory relief is backward-looking and “operate[s] as a penalty under § 2462” because “[a] public declaration that the defendants violated the law does little other than label the defendants as wrongdoers.” With respect to disgorgement, the court held that there is “no meaningful difference” between the plain-language definitions of “forfeiture” as used in § 2462 and “disgorgement,” and the court rejected the SEC’s distinction of the terms as “technical definitions” that Congress cannot be assumed to have meant to apply in the absence of clear indication in the statute. Having determined whether § 2462 applies to injunctive relief, declaratory relief, and disgorgement, the court declined to reach the issue of whether the limitations period is jurisdictional in nature.

Although the court agreed with the SEC’s position on injunctive relief, this holding is likely to be of little comfort to the agency. While reasoning that it would be “premature to review the precise nature of” an injunction the district court had not yet issued, the court noted that the injunction requested in the Graham complaint was the type of “obey-the-law” injunction—that is, an injunction prohibiting “the defendants from violating federal securities laws”—it has consistently held to be unenforceable. While the court reasoned that the issue was appropriate for consideration because it “is at least possible that the SEC could seek injunctive relief that would be specific and narrow enough that the parties would be afforded sufficient warning to conform their conduct,” it offered no opinion on what enforceable injunctive relief might look like.

U.S. Supreme Court to Take Up Issue of “Personal Benefit” in Insider Trading Context

The U.S. Supreme Court granted certiorari this week in a case that is sure to draw significant attention given its likely implications on insider trading liability. Bassam Salman filed the petition after the Ninth Circuit affirmed his insider trading conviction in United States v. Salman, 792 F.3d 1087 (9th Cir. 2015).

Salman was convicted of conspiracy and insider trading arising out of a trading scheme involving members of his extended family. During the time period at issue, Maher Kara, Salman’s future brother-in-law, had access to insider information regarding mergers and acquisitions of and by his firm’s clients that he provided to his brother, Michael Kara. Michael subsequently traded on the information. Michael then shared the information he learned from Maher with Salman. Salman also traded on the information.

Following his conviction, Salman appealed and argued that there was no evidence that he knew that Maher disclosed information to Michael in exchange for a personal benefit. The personal benefit requirement, first derived from the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983), requires that the insider personally benefit from the disclosure—including through pecuniary gain, a reputational benefit that will translate into future earnings, or where the insider makes a gift of confidential information to a trading relative or friend. Critical to the third manner of conferring a personal benefit, the Second Circuit recently held in United States v. Newman, 773 F.3d 438, 452 (2d Cir. 2014), that to the extent “a personal benefit may be inferred from a personal relationship between the tipper and tippee . . . such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”

Salman urged the Ninth Circuit to adopt the Newman court’s interpretation of Dirks to require more than evidence of a friendship or familial relationship between the tipper and the tippee. The Ninth Circuit declined, holding that doing so would require the court to depart from the ruling in Dirks that liability can be established where the insider makes a gift of confidential information to a trading relative or friend. The Supreme Court likely will resolve whether the concept of a personal benefit addressed in Dirks requires proof of an objective, consequential, and potential pecuniary gain—as the Newman court held—or whether it is enough that the insider and tippee shared a close family relationship.

The Newman decision has already resulted in the dismissal of insider trading charges against several individuals. The Supreme Court’s ultimate decision will therefore provide much needed clarity in this area, given the sharp split between the Second and Ninth Circuits on the issue.

SEC Opens New Funding Options with Regulation A+

Regulation A+ goes into effect June 19, 2015, allowing funding of companies by non-accredited investors. Smaller companies can offer and sell up to $50 million of securities in a 12-month period, subject to eligibility, disclosure, and reporting requirements. See Amendments for Small and Additional Issues Exemptions under the Securities Act.

The regulations allow two tiers of potential offerings. Tier 1 allows security offerings of up to $20 million in a 12-month period. Tier 2 allows security offerings of up to $50 million in a 12-month period but also requires audited financial statements, annual, semi-annual, and current-event reports, and a limitation on the amount of securities non-accredited investors can purchase of no more than 10% of the greater of the investor’s annual income or net worth. Tier 1 limits offers to not more than $6 million by selling security holders that are affiliates of the issuers, and Tier 2 limits offers to not more than $15 million.

All offerings under Regulation A+ will still require electronic filing of offering materials and other current practices for registered offerings under Regulation A. Offerings will also permit companies to submit draft offering statements for non-public review by SEC staff and allow companies to use solicitation materials after filing the offering statement.

The states of Montana and Massachusetts have both challenged Regulation A+ as arbitrary under the Administrative Procedures Act. Regulation A+ exempts offerings sold under Tier 2 from state blue sky laws. The SEC denied a stay to the implementation of the rules pending the outcome of these challenges. The rules could still be overturned in court, although agencies are given great deference under the Administrative Procedures Act so the success of these challenges is doubtful.

These rules were adopted pursuant to Title IV of the Jumpstart Our Business Startups (JOBS) Act of 2012. The SEC plans to adopt crowdfunding rules pursuant to Title III later in 2015 or 2016. Title III will allow startups to solicit as many unaccredited investors as they wish, though solicitations will be limited to $1 million annually.

Smaller companies may view Regulation A+ as a way to broadly raise funds without undergoing the rigorous requirements of registration under the Securities Act. However, companies need to remember that any offerings will still be subject to various federal laws and regulations and could open up companies and individuals to SEC investigations. Any disclosure statements must be accurate and truthful. Any misleading or incomplete offering materials or disclosures could result in civil enforcement proceedings by the SEC and/or prosecution by the Department of Justice pursuant to criminal fraud statutes.

Regulation A+ expands on Regulation A, a longstanding but rarely used exemption to registration under the Securities Act of 1933. Part of the reason that Regulation A has been so rarely used is because of the significant costs associated with compliance with SEC regulations. Although Regulation A+ allows access to a broader range of individuals as investors, the compliance costs will still be high.

Numerous SEC investigations and enforcement actions in this area are likely. In adopting these rules, the SEC is going to conduct a study and provide a report within five years “on the impact of both the Tier 1 and Tier 2 offerings on capital formation and investor protection.” See SEC Press Release: SEC Adopts Rules to Facilitate Smaller Companies’ Access to Capital. A higher degree of protection may be needed for the non-accredited investors who will be participating in these offerings. It is very likely that offerings under Regulation A+ will face close scrutiny.

The SEC has published a Small Entity Compliance Guide to assist companies in raising funds under Regulation A+.

Settlement with Large Firm Audit Partner Reaffirms SEC’s Emphasis on Related Party Disclosures

The SEC’s Division of Enforcement has made a concerted effort in recent months to warn auditors and other corporate “gatekeepers” that it intends to scrutinize the adequacy of related party disclosures in financial filings. This emerging trend continued on April 29, 2015, when the SEC announced the settlement of an enforcement proceeding against McGladrey LLP partner Simon Lesser. See Exchange Act Rel. 74827 (Apr. 29, 2015). Lesser, who served as lead engagement partner during McGladrey’s financial statement audits of investment advisory firm Alpha Titans LLC and several related private funds over a four-year fiscal span, settled claims that he engaged in improper professional conduct within the meaning of Section 4C of the Securities Exchange Act of 1934 and Rule 102(e)(1)(iv)(B)(2) of the SEC’s Rules of Practice. The SEC also alleged that Lesser willfully aided and abetted and caused his audit client to violate Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-2 thereunder.

Lesser’s settlement derived from assertions that Alpha Titans failed to adequately disclose related party relationships and material related party transactions in accordance with generally accepted accounting principles (GAAP). Specifically, Alpha Titans’s chief executive officer and general counsel were alleged to have transferred more than $3.4 million in client assets among the various funds to pay for adviser-related operating expenses during fiscal years 2009 through 2012. These payments purportedly were not agreed to by fund clients or authorized under the various operating documents. As asserted, Lesser knew about these related party relationships and the underlying transactions, which should have been disclosed under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 850, but, nonetheless, “gave his final approval for McGladrey to issue audit reports containing unqualified opinions.”

The SEC also claimed in the settlement that Lesser failed to ensure that McGladrey’s audits for each fiscal year were conducted in conformity with generally accepted auditing standards (GAAS). Lesser allegedly did not exhibit the requisite level of due professional care in that he “should have … place[d] greater emphasis on the related party relationships and transactions, and the adequacy of the related party disclosures.” The SEC further contended that Lesser did not obtain sufficient audit evidence or prepare audit documentation explaining adequately why he considered the financial statements GAAP compliant absent such related party disclosures. Without admitting or denying the SEC’s findings, Lesser agreed to a $75,000 civil penalty and a minimum three-year suspension from appearing or practicing before the SEC as an accountant.

Although the circumstances surrounding this particular proceeding were announced only last week, high-ranking SEC representatives began eluding to the likelihood of related party-based enforcement actions earlier this year. In late February, Julie M. Riewe, Co-Chief of the Division of Enforcement’s Asset Management Unit (AMU)—the same unit that conducted the investigation against Lesser—provided a revealing glimpse into AMU’s 2015 priorities during her presentation at the IA Watch 17th Annual IA Compliance Conference. Ms. Riewe cautioned:

For private funds—meaning hedge funds and private equity funds—the AMU’s 2015 priorities include conflicts of interest, valuation, and compliance and controls. On the horizon, on the hedge fund side, we anticipate cases involving undisclosed fees; all types of undisclosed conflicts, including related-party transactions; and valuation issues, including use of friendly broker marks.

(Emphasis added.)

Stephanie Avakian, Deputy Director of the Division Enforcement, provided parallel commentary in the context of auditors and other corporate “gatekeepers” during SEC Speaks 2015 in February. Ms. Avakian emphasized that accounting and financial reporting violations are considered an ongoing enforcement priority with particularized attention to related party disclosures.

Indeed, another recent enforcement proceeding further underscores that last week’s settlement with Lesser should not be construed as an isolated occurrence. The SEC announced a similar settlement with a Hong-Kong based auditing firm and two of its auditors in December 2014, involving an alleged “fail[ure] to uphold U.S. auditing standards and exercise appropriate professional care and skepticism with regard to numerous related-party transactions” not adequately disclosed by a Chinese-based oil company. See Press Rel. 2014-284, SEC Imposes Sanctions Against Hong Kong-Based Firm and Two Accountants for Audit Failures. The firm in that instance agreed to pay a $75,000 civil penalty with the two professionals agreeing to pay penalties of $20,000 and $10,000, respectively, and to accept three-year minimum suspensions. Accordingly, the enforcement action against Lesser is not the first recent settlement involving related party disclosures and, given the SEC’s pointed remarks earlier this year, it almost certainly will not be the last.

SEC Awards More Than One Million Dollars to Compliance Officer

On April 22, 2015, the SEC announced an award of between $1.4 million and $1.6 million to a compliance officer who provided original information to the SEC that led to the successful enforcement of a covered action. Exchange Act Rel. 74781 (Apr. 22, 2015). The Dodd-Frank Whistleblower rules generally exclude information that is obtained by an “employee whose principal duties involve compliance or internal audit responsibilities … .” 17 C.F.R. § 240.21F-4(b)(4)(iii)(B). This rule would ordinarily prevent those employees from qualifying as a Whistleblower. An exception applies, however, when the employee has “a reasonable basis to believe that disclosure of the information to the Commission is necessary to prevent the relevant entity from engaging in conduct that is likely to cause substantial injury to the financial interest or properly of the entity or investors … .” 17 C.F.R. § 240.21F-4(b)(4)(v)(A).

The SEC determined this exception was applicable here. According to Andrew Ceresney, Director of the SEC’s Division of Enforcement, “This compliance officer reported misconduct after responsible management at the entity became aware of potentially impending harm to investors and failed to take steps to prevent it.” Press Rel. 2015-73. Despite the limitation on compliance and audit employees to qualify as Whistleblowers, this is the second time the SEC has relied on the exception to make an award to an employee with compliance or audit responsibilities. Last August, the SEC announced an award of more than $300,000 to an employee who performed compliance and audit functions. Press Rel. 2014-180.

SDNY Judge Deals Rejects Constitutional Challenge to SEC’s Use of Administrative Proceedings

A former executive of Standard & Poor’s (S&P) Rating Services has lost an early constitutional challenge to the SEC’s use of administrative proceedings.

Barbara Duka filed suit in federal court in January, following the SEC’s decision to bring charges against her for violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, which prohibits fraudulent conduct in the offer and sale of securities. Duka, formerly a co-manager of the commercial mortgage backed securities group of S&P’s Rating Services initiated the suit to prevent her from being compelled to submit to allegedly unconstitutional proceedings. Duka sought a preliminary injunction, arguing that administrative law judges (ALJs) who preside over administrative proceedings, are unlawfully insulated from oversight by the President in violation of Article II of the Constitution. Last week, District Judge Richard M. Berman of the Southern District of New York rejected Duka’s request.

Duka presented her claim as a facial challenged to the constitutionality of SEC ALJ proceedings, which aided the court’s determination that it had subject matter jurisdiction to entertain the suit.

Duka’s constitutional challenge was premised on the argument that SEC ALJs are “inferior officers” protected from removal by at least two levels of good-cause tenure protection and therefore the President cannot oversee ALJs in accordance with Article II. In considering the likelihood of success on the merits of Duka’s constitutional claim, the court rejected the argument that the Supreme Court’s decision in Free Enterprise Fund v. Public Accounting Oversight Board, 561 U.S. 477 (2010), supported the conclusion that SEC administrative proceedings are unconstitutional. In Free Enterprise Fund, the Supreme Court decided that the SEC’s Public Company Accounting Oversight Board created by Sarbanes-Oxley violated Article II because the act provided for dual for-cause limitations on the removal of board members. The Supreme Court held that “such multilevel protection from removal is contrary to Article II’s vesting of the executive power in the President” and that the President “cannot ‘take Care that the Laws be faithfully executed’ if he cannot oversee the faithfulness of the officers who execute them. Id. at 484.

Judge Berman noted that the issue of whether ALJs are “inferior officers” is subject to dispute, but he did not need to resolve that question because it concluded that the level of tenure protection afforded to ALJs was permissible. The court reasoned that the Supreme Court in Free Enterprise Fund addressed the narrow issue of whether Congress may deprive the President of adequate control over the board. The court also noted that ALJs were specifically excluded from the reach of the Free Enterprise Fund holding. Id. at 507 n.10 (“For similar reasons, our holding also does not address that subset of independent agency employees who serve as administrative law judges.”). In addition, the court noted, the decision in Free Enterprise Fund “supports the conclusion that restrictions upon the removal of agency adjudicators, as opposed to agency officials with ‘purely executive’ functions, generally do not violate Article II.” Op. at 19. Here, the court concluded, ALJs perform “solely adjudicatory functions, and are not engaged in policymaking or enforcement.” Id. at 20.

The Duka decision is a setback for defense bar challenges to the SEC’s use of administrative proceedings. As we have written in the previous post: “SEC Faces New Constitutional Challenge to Administrative Proceedings Based on Tenure Protection of Administrative Law Judges,” the SEC has faced a flurry of challenges to the use of administrative proceedings, which provide fewer protections to litigants than those provided in cases brought in federal court. Despite the decision, it is likely that the SEC will continue to face such challenges as they make their way through the federal appellate courts.

SEC Uses Books and Records and Internal Control Regulations to Extend Reach of Actions Beyond Fraud

Last year, we predicted that the SEC would increase its use of administrative proceedings to enforce strict liability violations such as books and records and internal controls. See Mary P. Hansen & William L. Carr, The Future of SEC Enforcement Actions: Negligence Based Charges Brought in Administrative Proceedings, The Investment Lawyer, Vol. 21, No. 9 (September 2014). In a recent action, announced on April 1, 2015, the SEC did just that.

According to the SEC, Timothy Edwin Scronce, the majority owner and CEO of privately held TelWorx Communications, LLC (“TelWorx”), falsified TelWorx’s books to inflate its revenues leading up to and after the acquisition of TelWorx by a public company, PCTEL, Inc. (“PCTEL”). Exchange Act Rel. No. 74626 (Apr. 1, 2015). In particular, prior to the acquisition, Scronce directed TelWorx’s Controller, Michael Hedrick, to inflate the value of certain inventory and to invoice certain orders before they had shipped and then reverse the invoices so they could be invoiced again during the subsequent quarter. After the acquisition, Scronce instructed Hedrick to create dummy invoices for orders that Scronce himself intended to make to further conceal his conduct. In addition, once Scronce learned that a large order that had been postponed would not be placed in time to help meet the quarterly results, he instructed the Vice President of Sales and Tech Services, Marc J. Mize, to solicit a straw vendor that would purchase the product on an intermediate basis with the intent to prematurely recognize the income from this sale. The timing on this transaction ultimately would not obtain the benefit Scronce intended, and he instructed Mize and another employee to reverse the invoice and to enter a revised, false purchase order into the system. All of these actions caused PCTEL to materially overstate its income during the relevant period.

Based on these allegations, the SEC instituted proceedings against Scronce for violation of (1) “Section 10(b) of the Exchange Act and Rule 10b-5 thereunder which prohibit fraudulent conduct in connection with the purchase or sale of securities”; (2) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (3) “Section 13(a) of the Exchange Act and Rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading”; (4) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (5) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act.” Without admitting or denying the findings, Scronce agreed to disgorgement in the amount of $376,007; prejudgment interest in the amount of $29,212.47; and a civil monetary penalty in the amount of $140,000, and to a ten-year ban on acting as an officer or director of any issuer.

The SEC did not stop there, though. It also charged Hedrick and Mize for violation of (1) “Section 13(b)(5) of the Securities Act which prohibits the knowing falsification of any book, record, or account or circumvention of internal controls”; (2) “Section 13(b)(2)(A) of the Exchange Act, which requires Section 12 registrants to make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets”; and (3) “Rule 13b2-1 of the Exchange Act, which prohibits the direct or indirect falsification of any book, record or account subject to Section 13(b)(2)(A) of the Exchange Act,” none of which requires the SEC to prove that an individual acted with scienter. In addition, the SEC charged Hedrick with causing Scronce’s violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder and with causing “PCTEL’s violations of Section 13(a) of the Exchange Act and rules 13a-11 and 12b-20 promulgated thereunder, which collectively require issuers of securities registered pursuant to Section 12 of the Exchange Act to file with the Commission accurate current reports on Form 8-K that contain material information necessary to make the required statements made in the reports not misleading.”

Hedrick and Mize, like Scronce, agreed to resolve the charges without admitting or denying the findings. Each of them agreed to pay civil monetary penalties in the amount of $25,000. Notably, these sanctions do not reflect that Hedrick was charged with causing Scronce’s and PCTEL’s fraud violations, while Mize was only charged with strict liability violations.

We expect the SEC to continue using books and records and internal control charges to pursue companies and senior executives who play a role in fraudulent schemes, even where an individual did not act intentionally or even recklessly.