SEC Files First Antiretaliation Enforcement Case Against Hedge Fund Advisory Firm

In a first of its kind case, the SEC last week charged an investment adviser to a hedge fund with, among other things, retaliating against an employee who reported allegedly illegal trading activity to the agency. The SEC exercised its authority under a Commission rule adopted in 2011 under the Dodd-Frank Act, which permits enforcement actions based on retaliation against whistleblowers.

Under the Exchange Act, employers may not “discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower.” 15 U.S.C. § 78u-6(h)(1)(A). The Act also provides that the Commission “shall pay an award or awards to 1 or more whistleblowers who voluntarily provided original information to the Commission that led to the successful enforcement of the covered judicial or administrative action, or related action, in an aggregate amount equal to (A) not less than 10 percent, in total, of what has been collected of the monetary sanctions imposed in the action or related actions; and (B) not more than 30 percent, in total, of what has been collected of the monetary sanctions imposed in the action or related actions.” Id. § 78u-6(b)(1).

The alleged retaliation at issue centered on the investment adviser’s former head trader, who reported allegedly improper principal transactions to the SEC under the SEC’s Bounty Program. According to the SEC, the investment adviser engaged in trades with an affiliated broker-dealer on behalf of one of its hedge fund clients. The SEC alleged that the investment adviser’s owner had a conflicted role as owner of the brokerage firm while subsequently advising the hedge fund client. In an attempt to satisfy written disclosure and consent requirements, the investment adviser formed a conflicts committee to review the transactions, which consisted of the investment adviser’s CFO and chief compliance officer. The SEC alleges that the conflicts committee was also conflicted because the two-person committee reported to the investment adviser’s owner and because the investment adviser’s CFO also served as CFO of the investment adviser’s affiliated broker-dealer. As a result of this conflict, the SEC contended the investment adviser did not provide effective written disclosure to its hedge fund client, and it did not obtain consent to engage in the transactions.

According to the SEC Order, the trader subsequently informed the owner of the investment adviser that he had reported these potential securities law violations to the SEC. After the company learned of the whistleblower’s submission, it allegedly engaged in a series of retaliatory actions to strip the trader of his responsibilities. Approximately one month after doing so, the whistleblower resigned citing constructive discharge. Of note, the former trader filed a lawsuit against the investment adviser, its owner, and its affiliated broker-dealer under § 78u-6(h)(1)(B), which permits whistleblowers to bring enforcement actions, alleging unlawful retaliation, but the lawsuit was voluntarily dismissed in December 2012. It is not clear why the lawsuit was dismissed or whether the dismissal was related to a settlement.

In settling the matter with the SEC, the investment adviser neither admitted nor denied the charges. It agreed to pay $2.2 million, which includes disgorgement of $1.7 million, prejudgment interest of $181,771, and a civil penalty of $300,000. The Order expressly provides that the disgorgement relates to administrative charges relating to the principal transactions. The Order is silent, however, on whether the civil penalty of $300,000 is related to those principal transactions or has something to do with the retaliation claim. The Commission acknowledged in its order that the principal transactions were effected at the prevailing market price and the affiliated broker-dealer did not charge a markup or commission on the transactions. Significantly, the Order does not contain any finding that the funds were harmed by inadequate prices and the fact that the disgorgement relates to administrative charges strongly suggests there was a lack of monetary injury to the funds.

The SEC has authority to award the whistleblower between 10 and 30 percent of the recovery because the tip led to sanctions in excess of $1 million. According to Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, a whistleblower is eligible for a whistleblower award. We have previously pointed out that the SEC intends to vigorously protect whistleblowers by using it authority under Dodd-Frank to bring retaliation claims against employers in a previous post: “Arbitration Agreements and Whistleblower Protections.” This case is proof.

D.C. Circuit Court of Appeals Issues Ruling on Conflict Minerals

On April 14, 2014, the U.S. Court of Appeals for the District of Columbia Circuit issued its opinion in the conflicts minerals case, National Association of Manufacturers, et al., v. Securities and Exchange Commission. The Court of Appeals upheld most aspects of the statute and the rule, but found that the statute and rule violate the First Amendment “to the extent that the statute and rule require regulated entities to report to the Commission and to state on their website that any of their products have not been found to be ‘DRC conflict free.’” The Court of Appeals remanded the case to the U.S. District Court for the District of Columbia for further proceedings consistent with its opinion. As of this time, there is no reprieve for issuers from the requirement to file a Form SD or conflict minerals report with the Securities and Exchange Commission (SEC) by June 2, 2014.

Background

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress required that the SEC issue regulations requiring firms using “conflict minerals” to investigate and disclose the origins of those minerals. The SEC’s rule applies to issuers that file reports with the SEC under Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 (the Exchange Act) and for whom conflict minerals are necessary to the functionality or production of a product manufactured or contracted to be manufactured.

“Conflict minerals” are used in many different types of products and are defined as cassiterite, columbite-tantalite, gold, wolframite and their derivatives, tantalum, tin and tungsten. Many non-SEC reporting companies also have been impacted by the scope of the rule’s “reasonable country of origin” (RCOI) and supply chain due diligence provisions, notwithstanding the fact that the rule only applies to issuers. For more on the adoption of the conflict minerals rules and the specific requirements, see Drinker Biddle’s September 2013 Client Alert.

Court Ruling

The National Association of Manufacturers challenged the SEC’s final rule, raising Administrative Procedure Act (APA), Exchange Act and First Amendment claims. The District Court rejected all of those claims and granted summary judgment for the SEC and intervenor Amnesty International. On appeal, the Court of Appeals affirmed the District Court’s ruling on the APA and Exchange Act claims, but reversed the ruling on the First Amendment claim.

In particular, the Court of Appeals found that the requirement to disclose that products are not “DRC conflict free” violates the prohibition against compelled speech. The court explained:

The label “conflict free” is a metaphor that conveys moral responsibility for the Congo war.  It requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups . . . By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.

The Court of Appeals found insufficient the SEC’s argument that issuers could explain the meaning of “conflict free,” stating that “the right to explain compelled speech is present in almost every such case and is inadequate to cure a First Amendment violation.” Also of note, the Court of Appeals found that the SEC did not act arbitrarily and capriciously by choosing not to include a de minimis exception to the conflict minerals rules. As conflict minerals are often used in limited amounts, the Court of Appeals found that a de minimis exception could leave small quantities of conflict minerals unmonitored across many issuers.

Implications

Unfortunately for many issuers who are racing to complete their specialized disclosure report on Form SD and their first conflict minerals report, due by June 2, 2014, there is no reprieve from that deadline at this time. While it is difficult to predict what action the SEC may take, it is possible that the SEC could seek further review of the rule, could stay the upcoming filing deadline in light of the ongoing proceedings, or could otherwise clarify its expectations regarding disclosure obligations, although there are no guarantees. Given that uncertainty, it would be wise for issuers to continue to work on their Form SD and conflict minerals report unless and until the SEC takes further action.

Because the Court of Appeals upheld most aspects of the conflict minerals statute and rule, the due diligence requirements remain intact, and it is possible that they could survive with modified disclosure requirements.  Therefore, notwithstanding the Court of Appeals ruling, it is advisable that SEC reporting companies continue their due diligence efforts. For those companies who are not SEC reporting companies but who are nonetheless impacted by the conflict minerals rule via the required RCOI and supply chain due diligence process, it is advisable to continue responding to RCOI and due diligence inquiries.

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.”

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.