Enforcement Highlights

SEC Establishes Dedicated Group to Focus on Private Funds

Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, private funds have become the subject of heightened scrutiny by both the SEC’s Division of Enforcement and the Office of Compliance Inspections and Examinations (“OCIE”). Based on recent announcements, this trend is likely to continue.

In 2012, OCIE announced an initiative to conduct “Presence Exams” or focused, risk-based examinations of investment advisers to private funds who recently registered with the SEC. See the OCIE’s National Exam Program letter. More recently in the SEC’s 2014 CCO Outreach Program, the SEC announced that it had conducted 250 Presence Exams. The SEC added that many of the exams revealed “significant findings,” but did not disclose whether those findings led to enforcement referrals or were resolved in the deficiency letter process. The SEC reiterated that focus areas of the Presence Exams included: (1) investment conflicts of interest including personal and affiliates’ transactions and fees paid to advisers and expenses charged to funds; (2) marketing, including the use of placement agents and using past performance; (3) valuation; and (4) custody.

Recently, the SEC formed a new “group” within OCIE to focus on the approximately 1,500 newly registered advisers to private equity and hedge funds. The new group is being led by two “industry experts” hired by the SEC in the last few years and will include staff from four regional offices across the country. If the group is successful, the SEC intends to expand the unit to additional regional offices.

Traditionally, the SEC has created working groups or specialized units in the Division of Enforcement to focus on what it perceives to be high-risk areas, i.e., where investor funds are most at risk. The Division of Enforcement currently has five specialized units: (1) Market Abuse, (2) Asset Management, (3) Municipal Securities and Public Pensions, (4) Foreign Corrupt Practices Act, and (5) Complex Financial Instruments. These units were formed in significant part due to the criticism of the agency for failing to detect Bernie Madoff’s massive Ponzi scheme. Each of these units is led by a senior officer who reports to the Director of the Division of Enforcement and is staffed by members of regional offices across the country.

It is very likely that the new private equity group will coordinate closely with the Asset Management Unit as that unit has developed significant expertise with respect to hedge funds, investment advisers and private equity funds. One of the group’s leaders, Igor Rozenblit, was with the Asset Management Unit since 2010. Moreover, the Asset Management Unit has been very active in bringing “message” cases against the very funds that the new group is charged with policing.

In addition to forming the new group, the SEC has also asked Congress for additional funds to support its examination program. The SEC seeks to add 316 staff to its examination program. Currently, there are approximately 450 examiners, accountants and lawyers in 12 regional offices. If the SEC receives the additional funds, it could almost double the size of its examination staff allowing it to conduct significantly more exams and assist with more enforcement investigations.

In the last few months, the Division of Enforcement formed three other new “groups” to focus on different areas. Last summer, the SEC announced the creation of: (1) the Financial Reporting and Audit Task Force, (2) the Microcap Fraud Task Force, and (3) the Center for Risk and Quantitative Analytics. These groups, unlike the formal units, will not conduct investigation. They are intended to identify potential violations and make referrals to the investigative staff.

Quarterly Whistleblower Award Update

The SEC recently announced that it has denied whistleblower claims in connection with three different matters and awarded an additional $150,000 to the inaugural recipient of an award under the SEC’s whistleblower program.

The SEC denied a whistleblower award claim relating to its case against penny stock promoters for fraudulently hyping Anscott Industries. See SEC v. Esposito, No. 08:00494 T26 (M.D. Fla. June 30, 2011). In Esposito, the court entered final judgments against the defendants ordering them to pay more than $20 million in disgorgement and civil penalties in a fraudulent touting case. The SEC denied the award because (1) the claimant failed to submit the claim within 90 days of the Notice of Covered Action and failed to demonstrate such tardiness should be waived based on extraordinary circumstances as “claimant failed to diligently pursue the claim for award upon termination of the purported ‘extraordinary circumstances’”; and (2) the claimant failed to provide original information since claimant did not provide information for the first time to the SEC after the date of enactment of Dodd-Frank.

The SEC denied a second set of whistleblower award claims because claimant failed to demonstrate she provided original information. In what the SEC described as “an unusual award application,” the claimant did not contend she provided information directly to the SEC, but instead contends that she provided information to the U.S. Department of Housing and Urban Development (“HUD”) and the FBI, which in turn shared that information with the SEC. The claimant alleged that this information helped the SEC in its case against former officers of subprime lender New Century Financial Corp., who allegedly lied about the company’s losses from loan defaults. See SEC v. Morrice, No. 09-0426 (C.D. Cal.); SEC v. Mozilo, No. 09-03994 (C.D. Cal.). The SEC reached a settlement with the officers that included more than $1,000,000 in disgorgement and civil penalties. The SEC denied the award because (1) any information provided by HUD or the FBI to the SEC prior to the enactment of Dodd-Frank in July 2010 would not be original information under Rule 21F-4(b)(1)(iv) and (2) any information provided after July 21, 2010, failed to meet the procedural requirements that original information must be provided to the SEC in writing by the claimant under Rule 21F-9(b).

The SEC denied two other whistleblower award claims determining that the first claimant failed to provide original information that led to a successful enforcement action and that the second claimant did not timely submit his application in response to the Notice of Covered Action. The first claimant had provided information to the SEC both before and after the enactment of Dodd-Frank. With respect to the first claimant’s pre-Dodd-Frank information, the SEC reiterated that information provided by the claimant to the SEC before the enactment of Dodd-Frank in July 2010 did not constitute original information under Rule 21F-4(b)(1)(iv). With respect to the post-Dodd-Frank information, the SEC concluded that the information did not lead to a successful enforcement action. According to the SEC, under Rule 21F-4(c)(1)-(2), “original information ‘leads to’ a successful enforcement action if either: (i) the original information caused the staff to open an investigation, and the Commission brought a successful action based in whole or in part on conduct that was the subject of the original information; or (ii) the conduct was already under investigation, and the original information significantly contributed to the success of the action.” The SEC determined the second claimant did not submit his Form WB-APP (Application for Award for Original Information Submitted Pursuant to Section 21F of the Securities Exchange Act of 1934) within 90 days of the Notice of Covered Action as required by Rule 21F-10(b). The SEC rejected claimant’s argument the SEC lost his original, timely WB-APP because the late-filed WB-APP did not cross-reference an earlier submission, claimant did not argue he had filed an earlier WB-APP until the SEC issued its Preliminary Determination, the claimant did not produce a copy of his alleged original submission, the SEC did not find it after an “exhaustive review of [its] records,” and the claimant did not offer any explanation why he filed the “second” WB-APP if he already had filed a timely form.

The first person to receive an award under the SEC’s whistleblower program received another $150,000 after the SEC collected an additional $500,000 in the case. This award represents the maximum percentage payout (30%) under the whistleblower program. Sean McKessy, chief of the SEC’s whistleblower office, commented “[t]his latest payment shows that the SEC’s aggressive collection efforts pay dividends not only for harmed investors but also for whistleblowers,” and emphasized that “[a]s [the SEC collects] additional funds from securities law violators, we can increase the payouts to whistleblowers.”

Lawson and Doral Expand Whistleblower Protections

Two recent decisions interpreting the Sarbanes-Oxley Act have significantly expanded the protections available for federal whistleblowers and increase the potential liability for public companies and private companies that contract for public companies.

In Lawson v. FMR LLC, 571 S. Ct. __, 188 L. Ed. 2d 158 (Mar. 4, 2014), the U.S. Supreme Court held that SOX protects from retaliation not only the direct employees of public companies, but also employees of private contractors and subcontractors serving public companies. At issue in Lawson was the scope of the protected class in section 1514A of the statute:

No [public] company … or any officer, employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee in the terms and conditions of employment because of any lawful act done by the employee … to provide information, cause information to be provided, or otherwise assist in an investigation regarding any conduct which the employee reasonably believes constitutes a violation of section 1341, 1343, 1344, or 1348, any rule or regulation of the Securities and Exchange Commission, or any provision of Federal law relating to fraud against shareholders ….

18 U.S.C. § 1514A(a). The plaintiffs in Lawson were former employees of privately held companies that provide advisory and management services to a mutual fund, a public company. The mutual fund itself has no employees. The defendants argued that the plaintiffs could not bring whistleblower claims under SOX because the statute only protects those directly employed by the public company.

In a 6–3 opinion, Justice Ginsburg, writing for the Court, concluded that section 1514A shields employees of privately held contractors and subcontractors, including investment advisors, law firms, and accounting enterprises, that contract for public companies. The Court reasoned that “nothing in § 1514A’s language confines the class of employees protected to those of a designated employer.” 188 L. Ed. at 175. In addition to its textual interpretation of the statute, the Court recognized that including employees of contractors and subcontractors would comport with Congress’s goal of encouraging outside professionals to report fraud without fear of retribution.

In Stewart v. Doral Financial Corporation, No. 13-1349, 2014 U.S. Dist. LEXIS 22441 (D.P.R. Feb. 21, 2014), the U.S. District Court for the District of Puerto Rico addressed the standard for pleading protected conduct. The plaintiff claimed that he was terminated illegally after expressing concerns to the company’s audit committee that certain financial information would not be reported accurately in quarterly filings. Relying on the Department of Labor’s Administrative Review Board’s (“ARB”) decision in Platone v. FLYi, Inc., 2006 WL 3193772 (Dept’ of Labor Sept. 29, 2006), the company moved to dismiss the plaintiff’s claim for failing to plead that the alleged protected activity “definitively and specifically” implicated the federal laws upon which section 1514A is based. After Platone, however, the ARB abandoned the “definitively and specifically” standard in favor of a more liberal standard: that a plaintiff must only plead she had “a reasonable belief” the alleged protected activity that the reported conduct violated applicable federal law. Sylvester v. Parexel Int’l LLC, ARB Case No. 07-123, 2011 WL 2165854 (Dep’t of Labor May 25, 2011). Even though the First Circuit already had adopted the “definitively and specifically” standard, see Day v. Staples, Inc., 555 F.3d 42, 56 (1st Cir. 2009), the Doral court ruled that the ARB’s more recent “reasonable belief” standard controlled and that plaintiff’s pleading was sufficient, 2014 U.S. Dist. LEXIS 22441, at *19–24.

Both the Lawson and Doral rulings dramatically broaden the scope of whistleblower liability for public companies and private companies that contract for public companies. In fact, the dissent in Lawson points out that the Court’s interpretation gives section 1514A a “stunning reach” that will allow babysitters and cleaning staff who work for people employed by a public company to file federal cases claiming retaliation. And the Doral decision—which echoes the conclusions of the U.S. Courts of Appeals for the Third and Tenth Circuits—allows those claims to survive the pleading stage by demonstrating only that the employee had a reasonable belief that the perceived illegal conduct implicated the federal laws upon which SOX is based. Lawson and Doral demonstrate that it is vital for public companies and private companies who contract for public companies to have robust reporting policies in place to address employee complaints of misconduct.

Drinker Biddle & Reath LLP filed an amicus curiae brief in the Lawson case on behalf of the National Federation of Independent Business. That brief advocated that the whistleblower protections of section 1514A not extend to employees of private contractors and subcontractors of public companies.

Arbitration Agreements and Whistleblower Protections

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed the SEC to establish a “bounty program” for certain individuals who voluntarily provide the SEC with original information that leads to successful SEC actions resulting in monetary sanctions over $1,000,000. Dodd-Frank also prohibits employers from taking retaliatory action against employees who report potential violations to the SEC and authorizes an employee to bring a private action in federal court alleging retaliation. If successful, the employee may be entitled to reinstatement, double back pay, litigation costs, expert witness fees, and attorneys’ fees. See 18 U.S.C. § 1514A.

Dodd-Frank also provides that pre-dispute arbitration clauses are invalid and unenforceable. See id. at § 1514A(e)(2). This means companies and their executives or employees cannot agree to arbitrate Dodd-Frank whistleblower claims. But does this prohibition apply to employment contracts negotiated and entered into pre-Dodd-Frank? Based upon a handful of district court rulings, the answer is: possibly.

Most recently, in 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 granted the defendants’ motion to compel arbitration on the basis that the arbitration agreement at issue was 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.” 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. See Weller v. HSBC Mortg. Servs. Inc., No. 13-00185, 2013 U.S. Dist. LEXIS 130544, 2013 WL 4882758, at *4 (D. Colo. Sept. 11, 2013); Blackwell v. Bank of Am. Corp., No. 11-2475, 2012 U.S. Dist. LEXIS 51991, 2012 WL 1229673, at *4 (D.S.C. Mar. 22, 2012), report and recommendation adopted, No. 11-2475, 2012 U.S. Dist. LEXIS 51447, 2012 WL 1229675 (D.S.C. Apr. 12, 2012); Henderson v. Masco Framing Corp., No. 11-0088, 2011 U.S. Dist. LEXIS 80494, 2011 WL 3022535, at *3 (D. Nev. July 22, 2011); Taylor v. Fannie Mae, 839 F. Supp. 2d 259, 263 (D.D.C. 2012).

Several cases, however, view the prohibition on arbitration clauses from a different prospective and conclude that the prohibition has retroactive effect. See Pezza v. Investors Cap. Corp., 767 F. Supp. 2d 225, 234 (D. Mass. 2011); Wong v. CKX, Inc., 890 F. Supp. 2d 411, 422–23 (S.D.N.Y. 2012). In Pezza, the court followed the U.S. Supreme Court’s decision in Landgraf v. USI Film Products, 511 U.S. 244, 271 (1994), which directs courts to examine whether the statute at issue is one “affecting contractual or property rights” (and thus should not be applied retroactively) or is “conferring or ousting jurisdiction” (and thus may be applied retroactively). The court found that 18 U.S.C. § 1514A(e)(2) is more analogous to the latter because it “takes away no substantive right but simply changes the tribunal that is to hear the case.” The court in Wong found the court’s decision in Pezza persuasive and came to this same conclusion.

Employment agreements and their impact on whistleblowing activity is a hot topic at the SEC as well. Last year, a law firm that represents whistleblowers sent a letter to the Commissioners urging them to take action against what they believe were actions intended to prevent employees from reporting potential corporate violations to the SEC. See Letter to SEC Commissioners (alerting SEC of the use of settlement and severance agreements as a means to prevent reporting and whistleblower claims). Recent comments by Sean McKessy, Chief of the SEC’s Office of the Whistleblower, suggest the Commission may have taken those concerns to heart. Mr. McKessy warned, “[W]e are actively looking for examples of confidentiality agreements, separat[ion] agreements, [and] employment agreements that … in substance say ‘as a prerequisite to get this benefit you agree you’re not going to come to the commission or you’re not going to report anything to a regulator.” See article SEC Warns In-House Attys Against Whistleblower Contracts. Mr. McKessy also said that the SEC not only will penalize companies, but the “lawyers who drafted” such an agreement or language. Id. These comments warn employers and their lawyers to proceed with caution (if at all) when they are thinking about using an employment agreement as a means to curtail or deter Dodd-Frank reporting and claims.

SEC v. Jacobs May Signal Limit to Duty of Trust or Confidence Required to Prove Insider Trading Based on Misappropriation Theory

To prevail on an insider-trading claim pursuant to Section 10(b) of the Exchange Act and Rule 10b-5 thereunder based on the misappropriation theory, the SEC must prove that the defendant (1) misappropriated material, nonpublic information; (2) had a duty of trust or confidence; (3) breached that duty; (4) purchased or sold securities, or tipped another who purchased or sold securities, on the basis of that information; and (5) knew or should have known that he or she was trading or tipping others on inappropriately obtained information. Dirks v. SEC, 463 U.S. 646, 660 (1983). The SEC has identified three nonexhaustive circumstances that create a duty of trust or confidence; they are (1) when a person agrees to maintain information in confidence; (2) when there is a history, pattern, or practice of sharing confidences and the recipient knows or reasonably should know that the person communicating the information expects the recipient to maintain its confidentiality; and (3) when a person receives material, nonpublic information from his or her spouse, parent, child, or sibling. See 17 C.F.R. § 240.10b5-2(b).

The existence of “a duty of trust or confidence” and the SEC’s attempt to expand that duty beyond the traditional fiduciary relationship have been the subject of many a motion to dismiss. Courts, however, have routinely ruled that a duty of trust or confidence is not limited to traditional fiduciary relationships. For example, in United States v. Corbin, 729 F. Supp. 2d 607 (S.D.N.Y. 2010), the court acknowledged Rule 10b5-2’s presumption of a relationship of trust and confidence between spouses and held that the SEC adequately alleged that a husband and wife had a history of sharing business confidences that the wife obtained about impending acquisitions while working for a communications firm, and that the pair had a “domestic confidentiality policy” of sorts whereby the husband understood he could not share that confidential information. In United States v. McGee, 892 F. Supp. 2d 726 (E.D. Pa. 2012), the court concluded that the complaint adequately alleged a relationship of trust and confidence where the source of the information and the recipient had become friends through Alcoholics Anonymous and also had an agreement of confidentiality through their involvement with that organization. In SEC v. Conradt, 947 F. Supp. 2d 406 (S.D.N.Y. 2013), the Court concluded that the SEC adequately pleaded a relationship of trust and confidence by alleging that two friends over the course of eight months shared confidences regarding family illnesses, personal legal troubles, and work communications describing sensitive client holdings.

But two recent jury verdicts provide some hope to defendants. In SEC v. Jacobs, Case No. 13-cv-1289 (N.D. Ohio), the SEC alleged that Andrew and Leslie Jacobs violated Section 14 of the Exchange Act and Rule 14e-3, which pertains to insider trading specifically in the context of tender offers, and Section 10(b) of the Exchange Act and Rule 10b(5), which pertains to insider trading generally, when Leslie traded on information provided to Andrew by his close friend and brother-in-law, Blair Ramey. According to the complaint, although Ramey did not tell Andrew about the tender offer specifically, he was certain to have understood Ramey’s company was going to be acquired given the nature of the conversation. Ramey requested that Andrew keep their conversation confidential, and Andrew agreed to do so.

Although the jury found Andrew and Leslie liable under Section 14 of the Exchange Act and Rule 14e-3, it did not find them liable under Section 10(b) of the Exchange Act and Rule 10b(5). The distinction between these two claims is crucial—a finding of liability under Section 14 of the Exchange Act and Rule 14e-3 does not require the existence of a duty of trust or confidence while a finding under Section 10(b) of the Exchange Act and Rule 10(b)(5) does.

And, of course, the jury found entrepreneur Mark Cuban not liable for insider trading, even though the Fifth Circuit had concluded that the SEC adequately pleaded Cuban had a relationship of confidence because he agreed to keep confidential material, nonpublic information and also promised not to trade on the information, SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010).

Notwithstanding the expansive interpretation given to the duty of trust or confidence element by the SEC and the courts, the Jacobs and Cuban verdicts serve as a reminder that the jury may not always accept the SEC’s formulation of liability, even when that formulation has been the basis for numerous successful oppositions to motions to dismiss.