Global Financial Market Watch : Global Financial Lawyer & Attorney : K&L Gates Law Firm : Government Enforcement, Investment Management

Contacts: Diane E. Ambler, Michael J. Missal, Matt T. Morley, Mark D. Perlow

2009 brought a further transformation in the relationship between business and government. Regardless of political systems or philosophies, governments around the world became more dynamic and intrusive in response to the financial crisis.

This 2010 Annual Report, prepared by members of the K&L Gates Global Government Solutions initiative, contains concise articles that seek to forecast likely government actions and priorities regarding a broad spectrum of topics.

To view the report, click here.

• Email This
• Print
• Comments
• Trackbacks

 By: Richard A. Kirby and R. James Mitchell

On December 9, 2009, almost one year to the day that Bernard L. Madoff was revealed to have perpetrated the largest Ponzi scheme in history, the SEC revealed its position with respect to the approach that it believes the Securities Investor Protection Corporation (“SIPC”) should take in defining the net equity of Madoff claimants.

The SIPC Trustee has previously taken the position that net equity for Madoff’s victims should be measured on a cash-in/cash-out basis, rather than using the stated values on account statements fabricated by Madoff. This measure of net equity rejects all claims filed by victims whose net withdrawals equaled or exceeded their principal investments.

• Email This
• Print
• Comments
• Trackbacks

Matt T. Morley, Richard A. Kirby, and Andrew Edwin Porter

The Obama Administration has recently announced the formation of a task force designed to coordinate federal, state and local efforts to investigate and prosecute fraud and other financial misconduct. The Financial Fraud Enforcement Task Force (FFETF) expands and supplants an earlier task force created to combat corporate fraud in the wake of the Enron scandal.

While the simple reconstitution of a task force is unlikely to dramatically alter the law enforcement landscape, this development may be one part of a more sweeping set of changes that could result in considerable increases in the magnitude, focus and efficiency of efforts to pursue financial wrongdoing. 

• Email This
• Print
• Comments
• Trackbacks

By: Stephen J. Crimmins, Nicholas S. Hodge, Melissa S. Holmes, Thomas F. Joyce, Beth R. Kramer, Richard A. Kirby, Mary C. Moynihan, Megan B. Munafo, Gwendolyn A. Williamson, Roger S. Wise

The Fall 2009 Edition of K&L Gates' Investment Management newsletter is offered as a timely aid in addressing the myriad regulatory issues confronting the investment management industry. Watch for future issues discussing up-to-the-minute developments and trends in the industry.

To view the complete newsletter, please click here.

• Email This
• Print
• Comments
• Trackbacks

By: Mark D. Perlow

Congress, the media and the public have subjected the SEC to harsh criticism in recent months, charging that it failed to prevent the collapse of Bear Stearns and Lehman Brothers and to detect the long-running Ponzi scheme of Bernard Madoff. While the accusations are somewhat unfair – banking regulators failed to prevent the insolvency of many large depository institutions, and the Financial Industry Regulatory Authority also failed to detect the Madoff fraud – these charges have achieved considerable political traction, and many recent proposals for regulatory reform would strip authority from the SEC or merge it into a new or already existing regulatory agency, such as the CFTC.

SEC Chairman Mary Schapiro, however, has made clear that she intends to assert aggressively the continuing importance and relevance of the agency. In particular, in a recent speech, Chairman Schapiro made the case for the SEC and its distinctive brand of financial regulation. She stated her view that the capital markets require a different type of regulation than do financial institutions, one that is focused on the protection of investors rather than on the safety and soundness of key institutions. She argued that investor protection requires an agency that is independent and experienced in dealing with the capital markets, an implicit criticism of banking regulators as too closely tied to the banks they regulate. She detailed the SEC’s past regulatory achievements, including regulatory regimes that have fostered successful exchanges, clearing agencies, mutual funds, investment advisers and broker-dealers, all of which (other than the largest investment banks) have functioned without a systemic failure during the current crisis. Although she does not put it this way, she is arguing that if the SEC did not exist, it would have to be invented.

Nonetheless, Chairman Schapiro admitted that the SEC has not performed up to expectations recently, and she mapped out the agency’s recent efforts to revitalize itself. First and foremost, she emphasized that the SEC’s enforcement program would be tougher and more efficient. She signaled the SEC’s intention to bring “meaningful cases that have the greatest impact and send a strong message.” In an effort to achieve these goals, the agency has eliminated controversial procedures requiring the staff to get pre-approval of the full Commission to launch a formal investigation or to negotiate settlements that include penalties. In addition, the SEC will engage a consulting firm to help the agency determine how best to sort through the countless tips and complaints it receives each year. The agency will also improve training and hire staff analysts (who may not necessarily be lawyers) with more financial industry experience. These reforms will resonate with practitioners with experience of the bureaucratic ways of the enforcement program. Subjects of SEC investigations can expect to face an even more relentless Division of Enforcement.

Schapiro also summarized some of the key elements of the SEC’s current pipeline of cases, making clear the agency’s intent to bring “message” cases – 150 hedge fund investigations, two dozen municipal securities investigations, and 50 cases involving credit default swaps (“CDS”), collateralized debt obligations and other derivatives. Recently announced enforcement actions have filled out this story further: the SEC has brought several dozen cases against alleged Ponzi schemes; the first insider trading case based on transactions in CDS; a case alleging manipulation of a municipal securities market; a case alleging that an investment adviser did not have adequate procedures to protect against conflicts of interest in its proxy voting procedures; an action against the manager of a money market fund that broke the buck for allegedly inadequate disclosures; and a case against executives of a subprime lender for allegedly misleading investors about the riskiness of its loan portfolio.

As Schapiro pointed out, the SEC also has a full rule-making agenda. In April, it proposed reinstating the short-sale uptick rule (or some variant on it); in May, it proposed a revamp of the client asset custody regime for registered investment advisers, including proposals to require surprise audits and independent compliance reviews, with the clear intent to prevent another Madoff. The SEC has also issued a controversial proposal to provide public company and investment company shareholders with access to the company’s proxy statement both to nominate a short slate of directors and to propose amendments to company nomination process bylaws. Schapiro’s willingness to take up this topic, which has been considered in various forms almost since the creation of the SEC and vigorously opposed by many industry groups, reflects her determination to restore the agency’s reputation with the public by picking a high-profile fight. Later this month, the SEC will propose new rules on money market funds, and is considering an expansion of the municipal pay-to-play rules and municipal securities disclosure, new rules regulating hedge funds, and seeking authority over whistleblower actions.

The Obama Administration has stated that it wants to see Congress pass a financial regulatory bill by the end of the year, and the chairs of the relevant Congressional committees have agreed to this timetable. The SEC is on a mission to demonstrate its importance and competence before the serious legislative sausage-making begins in the fall, all against the backdrop of deep public disillusionment with the financial sector. As one aspect of that campaign, subjects of SEC investigations and examinations, and industries targeted in SEC rulemaking proposals, should expect a tougher fight than at any time in recent memory.

• Email This
• Print
• Comments
• Trackbacks

By: Richard A. Kirby, Rebecca L. Kline Dubill, Scott P. Lindsay

On March 12, 2009, Bernard Madoff pleaded guilty to 11 counts of a criminal information filed by the U.S. Attorney’s Office for the Southern District of New York (“S.D.N.Y.”).  The information seeks forfeiture of all proceeds traceable to the commission of Madoff’s fraud in an amount “exceeding” $170 billion.  Assuming that the government can recover any additional assets through the exercise of its criminal or civil forfeiture powers, questions remain as to whether and how those assets will be distributed to Madoff’s victims.  Two recent large-scale securities fraud cases, Adelphia Communications Corp. and the Bayou Group, illustrate how protracted this process can be for victims.

Criminal forfeiture is a powerful tool that permits the government to seize a defendant’s assets that were used in, or were the fruits of, criminal activity.   The government also has civil forfeiture powers and can seize property related to criminal activity even if it does not belong to a convicted defendant.  Although as a separate matter the trustee appointed by the Securities Investor Protection Corp. (“SIPC”) in the Bernard L. Madoff Investment Securities, LLC (“BMIS”) liquidation proceeding is also seeking to recover BMIS assets, the full range of the government’s forfeiture powers are broader than those of the SIPC trustee and may result in additional assets being recovered. 

Typically, forfeited assets are distributed to crime victims in one of two ways: (1) the petition for remission process, in which victims apply for remission from a victims’ fund administered by the U.S. Department of Justice (“DOJ”); or (2) restitution, in which the U.S. Attorney General “restores” the forfeited assets to the court overseeing the criminal cases, and the court distributes funds to victims through an order of restitution. 

In the Adelphia case, John and Timothy Rigas were convicted in 2004 on various counts relating to their looting of Adelphia’s corporate assets and forced to forfeit significant personal assets, including their Adelphia stock.   In 2005, pursuant to a non-prosecution agreement, the company that the Rigas’ had controlled, Adelphia, agreed to repurchase this forfeited stock for $715 million, which was paid into a victims’ compensation fund.  This victims’ fund is administered by DOJ under the petition for remission process and has faced substantial litigation over its protocols.  As a result, nearly nine years after the fraud was revealed, no distributions from the fund have yet been made to Adelphia’s creditors or shareholders. 

Bayou involved a $400 million Ponzi scheme.   In their plea allocutions, the Bayou principals agreed to forfeit both personal and corporate assets, including $100 million in Bayou funds, as well as several dozen Bayou investment assets.  The S.D.N.Y. U.S. Attorney’s Office appointed a receiver to collect and liquidate the assets so that they could be restored to the court overseeing the criminal proceedings for distribution to victims through an order of restitution.  Although the U.S. Attorney’s Office obtained possession of the $100 million in cash and other investments as a part of the preliminary forfeiture orders, it took almost three years to distribute the forfeited assets to victims.  The restitution process was further complicated and delayed due to litigation initiated by former investors, who had been sued in the Bayou bankruptcy on a clawback theory for return of fictitious profits and principal.  These former investors succeeded in establishing themselves as contingent victims for purposes of the restitution fund. 

If Adelphia and Bayou serve as a guide, it likely could be years before Madoff’s victims receive any distribution of property seized by the government through the exercise of its forfeiture powers.   This may provide an opportunity — given the massive scale of the fraud and the quasi-governmental nature of SIPC — for the government to chart a different course and use the established SIPC liquidation proceeding to distribute any assets it seizes to victims of Madoff’s scheme through a transfer of forfeited assets to the SIPC trustee.  Such a transfer could expedite the ultimate distribution of funds to Madoff’s victims and create certain efficiencies in the processing of claims and the handling of objections.  While it remains to be seen whether the government will be successful in identifying and seizing assets not already under the control of the SIPC trustee, it is not too soon to consider an alternative paradigm to the government’s traditional and slow-working forfeiture distribution mechanisms. 

• Email This
• Print
• Comments
• Trackbacks

By: Matt T. Morley, Michael D. Ricciuti

The triggering event for the SEC’s action against Stanford International Bank, Ltd. and several of its senior executives appears to have been the abrupt public resignation of the company’s outside counsel.  This occurred the day after SEC testimony by one of Stanford’s executives, Laura Pendergest-Holt.  In apparently making what is known as a “noisy withdrawal,” counsel resigned and disavowed to the SEC all prior statements made by them in the matter.  The SEC promptly filed an action against Stanford and several executives, including Ms. Pendergest-Holt, who was also arrested on obstruction of justice charges.

In connection with the SEC’s investigation, company counsel had represented both the company and Ms. Pendergest-Holt.  According to press reports, counsel told the SEC that he represented the witness “insofar as she is an officer or director of one of the Stanford-affiliated companies.”  In many cases, it is potentially more efficient for company counsel to also represent individual officers and directors in government investigations.  But doing so often poses serious risks for conflict.  Although we do not know, and may never know, what precisely caused counsel to resign in the Stanford case, these events serve as a reminder of the risks involved where several parties share the same lawyers.  In such cases, parties need to consider in advance whether separate counsel should be retained and, if not, what will occur if a conflict subsequently arises.

When law enforcement officials first contact a company, it may seem – and may be the case – that the interests of individual employees are fully aligned with those of their employer. In some cases, at the outset of a criminal or SEC investigation, when the facts and/or the scope and focus of the probe may be unclear, corporate counsel may jointly represent the corporation and its individual officers, directors, and employees.  Pursuant to Rule 1.13 of the Model Rules of Professional Conduct, such joint representation is permissible as long as it does not involve a conflict of interest.  For example, in the event that an individual becomes a “subject” or “target” of an investigation – that is, someone who may be indicted as the result of a criminal probe – joint representation of the company and any such individual is not possible, and the employee will need separate counsel.  Other circumstances, such as the discovery of additional facts, may also give rise to conflicts of interest between the company and its employees.

Indeed, in the internal investigation context, where company counsel represents only the company, employees are ordinarily provided with “Upjohn” warnings, making clear counsel is acting solely for the company, and that while the interview may be subject to the attorney-client privilege, the company and not the employee controls whether to assert that privilege.   Employees are told that the company remains free to waive the privilege and disclose the substance of the interview to third parties, including the government, as part of its effort to cooperate. 

Where company counsel also represents an employee, however, the Upjohn warning doesn’t fit, because counsel also has attorney-client relationships both with the company and with the employee, and the employee’s confidences cannot be revealed without his or her consent.   If the interests of the company and the employee diverge, a number of critical issues will promptly arise.  Counsel will generally be unable to represent both the company and the employee, and a change in representation will be required.  Will the individual be required to get separate counsel?  If that occurs, will company counsel remain free to represent the company?  If so, what will happen to the employee’s confidences that have been shared with company counsel?  Will the company be free to use that information as it chooses?  Will the company be able to disclose this information to the government?  The failure to resolve these questions in advance can harm both the company and the individual involved and thus, in a joint representation, it is wise to reach a clear and common understanding from the outset as to what will happen if the parties develop conflicting interests or objectives. 

These questions take on even greater significance given that, in recent years, it has become increasingly common for the SEC to cooperate closely with criminal authorities.  Documents and witness statements may be shared with criminal prosecutors without notice to the company or its employees – and in the current environment, one should assume that almost any SEC investigation involves criminal charges.  Indeed, press reports indicate that, at the beginning of Ms. Pendergest-Holt’s SEC testimony, counsel tried without success to learn whether there was a parallel criminal investigation in the matter.

No single solution to these issues can fit every situation, but there are a variety of ways to address these issues.  At a minimum, where counsel will represent multiple interests, the engagement letter should spell out the parties’ agreement as to what will happen in the event of a conflict.  Sometimes, individuals may decide to retain “shadow” counsel, who are fully involved in providing advice and preparing for testimony, but who may not make a public appearance in the matter.  In other circumstances, separate counsel may be the best choice.  One thing remains clear – those who become the focus of attention by government authorities need to consider these issues at the very start.

• Email This
• Print
• Comments
• Trackbacks

By: Robert V. Hadley,  Matt T. Morley

On 5 January 2009 the FSA imposed a penalty of £5.25 million on the insurance brokerage firm Aon Limited because the firm lacked adequate systems and controls to address the risk that third parties would make corrupt payments to assist Aon in winning business in overseas jurisdictions.  See http://www.fsa.gov.uk/pubs/final/aon.pdf.  The FSA’s Final Notice alleged that due to these failures, the firm had made sixty-six "suspicious payments" totalling more than US$5 million.  The Final Notice, which Aon consented to, states that the firm’s procedures failed to require adequate training of relevant personnel as to bribery and corruption risks, adequate due diligence prior to the retention of third party representatives, and appropriate monitoring of those relationships going forward.  In addition, Aon’s supervisory committees were not provided with adequate information or otherwise did not assess whether the firm’s corruption risks were being effectively managed.

The FSA’s action is particularly notable for several reasons.

• While the FSA is not directly empowered with jurisdiction over domestic or foreign corruption offenses, which are ordinarily the responsibility of the police or the Serious Fraud Office ("SFO"), the FSA has a specific statutory objective to prevent financial crime.  The Final Notice makes clear that Aon was fined for breaches of FSA Principle 3 ("A firm must take reasonable care to control its affairs responsibly, with adequate risk management systems").  Conceivably, the FSA could also act in such cases under Principle 1 ("a firm must conduct its business with integrity").  Of course, a firm is likely to more readily agree to a public statement of a systems and controls failure than to acting without integrity, but, for the FSA, the level of fine, the publicity, and the resulting deterrent value of the FSA action remains the same.
  
   
• Aon already had in place a policy that prohibited corrupt payments such as the ones that came to light.  Yet, as US law enforcement authorities have so often emphasized with regard to the US Foreign Corrupt Practices Act, a “paper program” is not enough, and firms must also take additional steps, such as training, due diligence, monitoring and auditing, in a meaningful effort to assure compliance.
  
   
• Aon promptly self-reported to the Serious and Organised Crime Agency ("SOCA") and the FSA its discovery of the questionable payments.  The firm went on to conduct its own internal review of its anti-bribery systems and controls, and all payments to third party representatives for the previous six years.  Aon implemented all recommendations resulting from this review, and took disciplinary action against personnel found to have been involved.  Aon co-operated fully with the FSA's investigation.  While these steps, and the cost involved, were taken into account by the FSA when assessing/agreeing the financial penalty imposed, the firm did not avoid sanctions.

Margaret Cole, the FSA's Director of Enforcement, said that the fine "sends a clear message to the UK financial services industry that it is completely unacceptable for firms to conduct business overseas without having in place acceptable anti-bribery and corruption systems and controls".  Ms. Cole added that the FSA "has an important role to play" in UK steps against overseas corruption.

There are at least two important messages being sent by the FSA by its action against Aon.  First and most clearly, the case makes clear that the FSA expects regulated firms to have effective anti-corruption compliance measures in place – not simply a policy prohibiting corrupt payments, but coordinated efforts to require training of relevant personnel; due diligence on agents and other intermediaries acting on the firm’s behalf; monitoring and auditing compliance with the policy; and disciplinary action where violations of the policy occur.  Firms that fail to take these steps face potential sanctions under Principle 3.

Beyond this, the Aon case sets the precedent that in the eyes of the FSA regulated firms are required to self-report potential overseas corruption violations to the FSA.   FSA Principle 11 provides that "a firm must deal with its regulators in an open and cooperative way and must disclose to the FSA appropriately anything relating to the firm of which the FSA would expect notice."  We know the FSA's position from the Aon case, notwithstanding the FSA’s lack of criminal jurisdiction over such conduct, and that such matters are discloseable under Principle 11 also follows from the fact that firms are authorised by the FSA and individuals are approved by the FSA on the basis of their being "fit and proper." 

Disclosure of such matters may also be driven by the obligation of persons in the regulated sector (very broadly the financial services industry) to inform the SOCA where there is a suspicion of money laundering under the Proceeds of Crime Act 2002.   UK prosecutors regard any revenue from a contract obtained through a corrupt payment or offer of payment as the proceeds of crime, so that possession or any dealing with such funds is potentially a money laundering offence. Accordingly, the risk of a failure to disclose an offence or the need to set up a defence of SOCA's consent by disclosure to SOCA arises in almost every case where there is a suspicion of corruption. Once the need or obligation to make a report to SOCA is triggered, a regulated firm would be taking a serious risk by not also disclosing to the FSA under Principle 11. 

Overseas corruption is a hot topic in England and Wales, and the SFO has also taken recent steps to increase enforcement activity, increasing its manpower dedicated to looking at these matters by over 50% in 2008.  Last year saw the first UK convictions for overseas corruption, with the conviction of the head of the British company CBRN in connection with security services contracts in Uganda (see: http://www.guardian.co.uk/uk/2008/sep/23/ukcrime.law).  The SFO also reached a settlement with the construction company Balfour Beatty, in which that company admitted to historic accounting irregularities in some of its African operations.  Balfour Beatty paid a civil fine of £2.5million and was not subjected to criminal prosecution.  This case can be seen as a model for the SFO’s efforts to create a culture of self-reporting and to increase deterrence in the overseas corruption field.  In this way, the SFO can be seen to be taking enforcement steps without running the risk of a failed prosecution.

Both the SFO’s settlement with Balfour Beatty and the FSA's approach to Aon bear a strong resemblance to efforts by the US Securities and Exchange Commission and the US Department of Justice to pursue violations of their anticorruption statute, the US Foreign Corrupt Practices Act.  The great majority of such cases are resolved by violators consenting to the entry of court orders finding legal violations and imposing significant financial penalties as well as disgorgement of profits, as in the recent case involving Siemens AG and the imposition of more than $1 billion in fines.  As in the Siemens case, a further condition of these kinds of settlements is the creation of remedial programmes and the installment of external monitors, at the company’s considerable expense, empowered to review the firm's anti-corruption programmes for several years and report back to law enforcement authorities.  Self-reporting of potential violations is also encouraged by US authorities, who state that the consequences of violations will be less severe for those who come forward voluntarily. 

It remains to be seen whether the SFO’s resolution of the Balfour Beatty case will provide a model for future cases, but in the financial services arena, the die seems to have been cast by the Aon case by the rather straightforward application of the FSA’s Principles to require regulated firms to implement anti-corruption compliance programs.

• Email This
• Print
• Comments
• Trackbacks

By: Paul F. Hancock

State attorneys general aspire to be the primary protectors of consumers. The housing collapse provided new opportunities for them to flex their muscles and seek a role in the development of solutions.  Federal preemption remains a controversial issue, but the threat of preemption has only caused state attorneys general to be more aggressive in the areas where they have legal authority.   Recently elected attorneys general have pledged to focus attention on the housing and financial markets, and we can reasonably expect attorneys general, as a group, to push the limits of their authority in addressing the issues.  Some examples of their actions in recent months are described below.

Auction-Rate Securities
Allegations of deception have provided a basis for attorney general involvement in auction-rate securities markets.  New York Attorney General Cuomo reached agreement with twelve financial institutions on claims that they “sold auction-rate securities as safe, cash-equivalent products, when in fact they faced increasing liquidity risk.”  The institutions agreed to buy back the securities from certain customers, generally individuals and foundations, and otherwise provide restitution to “individual investors who were fraudulently sold auction-rate securities.”  Cuomo says that the settlements “returned over $50 billion back to investors’ hands.”  Similar settlements were reached by attorneys general in Massachusetts and Michigan.

Mortgage Fraud
Attorneys general have identified mortgage fraud, particularly inflated appraisals, as a major contributor to the housing crisis.  The Florida Attorney General sued ten companies and fifteen individuals that defrauded lenders by recruiting “straw buyers'” with good credit and conspiring with realtors to artificially inflate purchase prices.  Other states have filed similar claims.

Foreclosures
The State Foreclosure Prevention Working Group released its third report on mortgage foreclosures at the end of September, contending that 80 percent of delinquent borrowers are not receiving meaningful foreclosure relief.  Although the Group’s collaboration with servicers is described as cooperative, a stronger stick is laying in wait.  After a number of states announced a settlement with Bank of America regarding the Countrywide portfolio that centers on loan modification, on October 7, the Group sent a letter to sixteen subprime servicers stating: “We urge you in the strongest possible terms to adopt a comprehensive, streamlined, and effective loan modification program as soon as possible.”  The implicit threat of prosecution is clear.

State attorneys general investigated and prosecuted deceptive conduct by foreclosure rescue companies.  This issue is a neat fit for traditional attorney general enforcement and is a priority in many states.

Loan Origination
The settlement with Bank of America regarding the Countrywide portfolio continues a trend of aggressive state attorney general action regarding home mortgage lending practices.  The attorneys general already have extracted major business changes in the lending industry through lawsuits and compelled settlements.  The monetary value of the attorney general settlements with Household ($484 million) and Ameriquest ($295 million), as well as the extensive loan modification relief obtained from Countrywide, certainly overshadow any action by federal agencies.  The only real question is which firm will be the next target – perhaps one of the sixteen servicers that received the October 7 letter, or the originators of the loans that they are servicing.

2008 Attorney General Elections
Eleven seats were up for election and the announced plans of the winners indicate a continued, and perhaps increased, focus on mortgage and financial markets. 

Chris Koster, newly elected in Missouri, and Richard Cordray, newly elected in Ohio, focused their campaigns on credit and foreclosure issues.  Other well-known attorneys general who already enjoy a strong reputation in seeking mortgage reform and foreclosure relief – such as Roy Cooper in North Carolina and Rob McKenna in Washington – were reelected.  Mark Shurtleff was reelected in Utah, as was Darrell McGraw in West Virginia; they have prioritized mortgage fraud and other credit-related issues.

First-term attorneys general were elected in Indiana (Greg Zoeller), Montana (Steve Bullock) and Oregon (John Kroger), and incumbents were reelected in Pennsylvania (Tom Corbett) and Vermont (William Sorrell).   All emphasized the importance of consumer protection in seeking office.

Conclusion
The states want a place at the remedial table.   Some offer an olive branch of cooperative efforts to work through the present crisis.  Others are more aggressive from the start.  But if conditions do not improve quickly, it can be expected that many states will join forces to compel reform, based on claims that consumers and investors were deceived or otherwise were victims of unfair practices of loan originators, servicers or secondary market participants.

• Email This
• Print
• Comments
• Trackbacks

By Michael D. Ricciuti,  Clarence H. Brown and Leanne E. Hartmann

With the advent of the credit crisis, the Department of Justice (DOJ) – and particularly the Federal Bureau of Investigation (FBI) and the United States Attorneys’ Offices – is faced with a daunting challenge at a time of decreasing budgets and strained resources. DOJ’s resource shortage presents an enhanced strategic opportunity to corporations who suspect that they are at risk for investigation or prosecution for criminal activity – or have been victimized by it. In brief, sometimes the distinction between a criminally culpable company and one that has been victimized is in the eyes of the beholder. Emphasizing the latter status serves as an opportunity.

Background. After the events of September 11, 2001, DOJ and the FBI made national security their top priority, but with a more refined focus. No longer was it enough for DOJ to investigate and prosecute terrorists. Instead, DOJ now seeks to prevent acts of terrorism – a far more difficult task than merely prosecuting terrorism, which are among the most challenging criminal cases. Unsurprisingly, to fulfill this aggressive mission, a huge portion of the resources of the FBI and DOJ were redeployed to fight terrorism. Now, with the massive credit crisis to contend with, DOJ and FBI have opened a series of financial investigations, reportedly involving Freddie Mac, Fannie Mae, Lehman Brothers, and AIG, among approximately 1,500 others. Reports indicate that the FBI plans to double the number of agents focusing on financial crime, but also make clear that the FBI has hundreds fewer agents focused on this work than it did during the financial crisis involving savings and loans in the 1980s. It will be extremely challenging for the government to find the resources to handle these new complex and difficult cases.

Internal Investigations: Defensive Use. As discussed in the previous Global Financial Markets Group newsletter, the government has wide authority to bring charges in the corporate criminal context, but its own policies restrict its power to do so. In brief, a corporation may be criminally liable for the conduct (or omissions) of its agents committed within the scope of their duties and intended, at least in part, to benefit the corporation. This means that, as a matter of law, the crimes of any employee in the organization, regardless of his or her position on the organization chart, may be attributable to the company and the company could thus be charged criminally for them. DOJ has the discretion to bring a criminal case against the company under these circumstances – or not to do so. Whether DOJ exercises its discretion not to charge a company depends upon its analysis of the factors under DOJ’s Principles of Federal Prosecution of Business Organizations (“the Principles”). The Principles put a premium on a company’s cooperation in helping DOJ investigate the alleged crime – exactly the type of cooperation DOJ sorely needs now that it is facing a global financial crisis and its own resource shortage.

Revised this past August, the Principles recognize that corporate crime is more difficult to investigate than crimes committed by individuals. As the Principles note:

In investigating wrongdoing by or within a corporation, a prosecutor is likely to encounter several obstacles resulting from the nature of the corporation itself. It will often be difficult to determine which individual took which action on behalf of the corporation. Lines of authority and responsibility may be shared among operating divisions or departments, and records and personnel may be spread throughout the United States or even among several countries. Where the criminal conduct continued over an extended period of time, the culpable or knowledgeable personnel may have been promoted, transferred or fired, or they may have quit or retired.

Because of these difficulties, the Principles acknowledge that “a corporation’s cooperation may be critical in identifying potentially relevant actors and locating relevant evidence, among other things, and in doing so expeditiously.” (For more information regarding the Principles, see the United States Attorney’s Manual, Title 9, Chapter 9-28.700 et seq.)

From a defensive perspective, then, the company may seek to curry favor from DOJ and avoid being criminally charged through its cooperation. In cooperating under the Principles, a company with a good track record of compliance seeks, in essence, to demonstrate to the government that it should not be charged criminally on the basis of an employee’s criminal acts because that employee’s activities are inconsistent with the company’s otherwise positive compliance record, among other factors. Typically, conducting an independent internal investigation is a critical initial element in the company seeking credit for cooperation. Through an investigation of itself, the company discovers the relevant facts and – if it chooses to do so – can provide DOJ with a roadmap of the potential case from it. From DOJ’s perspective, cooperation credit is awarded where the corporation “timely disclosed the relevant facts about the putative misconduct” – and can result in DOJ not seeking to prosecute an otherwise well-run, compliant company because of its cooperation, among other factors.

There are significant risks to providing this cooperation. For instance, preparing an internal investigation develops a factual record which private litigants may later use to assert claims against the company and its officers and directors. Even so, with DOJ in short supply of agents to perform detailed investigations, providing this cooperation may be at a premium for the government – and may earn companies significant consideration when DOJ decides whether to bring criminal charges against the corporation. With an internal investigation in hand, companies can also often reap other benefits, such as identifying personnel who should be terminated for misconduct and deficient systems and procedures that need improvement, preparing earlier for shareholder and third-party litigation, and permitting the company to more effectively assist its board members, officers and employees in preparing for and giving testimony.

Internal Investigations: Offensive Use. There is also an offensive aspect to the use of internal investigations that is often overlooked. A company that suffers from the criminal conduct of an employee may be a defendant in a resulting prosecution – but may also be a victim of the wayward employee’s criminal acts. The company’s status as a victim is a fact on which the government does not always focus. A company thus should consider whether to use an internal investigation to proactively prod the United States Attorney’s Office to bring a criminal case against the employee wrongdoer. When the government is strapped for resources, it will often look favorably on a completed investigation that shows readily provable criminal wrongdoing, which will increase the likelihood that the government will take the case and prosecute it. Offensive use of the internal investigation accomplishes at least three goals:

First, it makes it clear to DOJ that the company should not be viewed as a potential defendant but rather as a victim, and, as such, is entitled to victim’s rights, to include the right to restitution from the employee. In a fraud case, where an employee has made off with company funds, a court in sentencing a convicted employee wrongdoer is empowered to order restitution as an element of the criminal judgment – forcing the employee to repay the company through a restitution order enforced by the Probation Department, U.S. Attorney’s Office, and the Court. Such an order saves the company from pursuing repayment from the employee civilly, often an expensive and fruitless endeavor.

Second, seeking prosecution from the government is often relatively inexpensive. Once the internal investigation is done by the company, and the government accepts the case for prosecution, it is the government that bears the costs of the prosecution. The company only needs to cooperate with the government, typically far cheaper than defending itself and its employees in a criminal probe.

Third, a prosecution of a criminal employee sends a very clear message to other employees and to the government that the company will not tolerate criminal wrongdoing and will take very aggressive action against those who violate the rules. There can be no clearer zero-tolerance approach for criminal activity.

Conclusion. With DOJ facing a likely crush of new financial crimes cases, companies with potential exposure need to consider their options strategically. One important option is a credible, independent internal investigation done early and proactively, which can provide the company with both defensive and offensive benefits.

• Email This
• Print
• Comments
• Trackbacks

By: Brian A. Ochs

On September 19, 2008, the SEC announced a “sweeping expansion” of its ongoing investigation into possible market manipulation in connection with short selling in the securities of financial institutions. (LINK)  The investigation is focused on broker-dealers, hedge fund managers, and institutional investors with significant trading activity in financial issuers and with positions in credit default swaps.

As part of the investigation, the SEC is invoking its authority under section 21(a) of the Securities Exchange Act of 1934 to require certain information in the form of sworn, written statements.   According to published reports, the first of these demands was sent out on September 22 to more than two dozen hedge fund managers, requiring information relating to AIG, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Washington Mutual.  The SEC seldom invokes its section 21(a) power in enforcement investigations — usually opting to subpoena documents and testimony instead — and the fact that the Commission is doing so in this instance indicates the speed and seriousness with which the SEC plans to pursue these investigations.

The SEC’s expanded investigation promises heightened scrutiny of two issues which have been the subject of enforcement focus since early this year: the dissemination of false rumors to the marketplace as part of short selling schemes and abusive “naked” short selling.

• False rumors and short selling
  
  
  • Last April, the SEC brought its first case alleging that a trader engaged in market manipulation by selling a company’s stock short at the same time that he intentionally disseminated a false rumor that had a depressing effect on the stock price. See SEC v. Paul S. Berliner (April 24, 2008). (LINK)  Other investigations are in progress, as well as an industry-wide sweep examination undertaken in conjunction with FINRA and the NYSE, that is focused on whether broker-dealers and investment advisers have reasonable controls and procedures to prevent the intentional creation or dissemination of false information. (LINK)
    
     
  • Given the prevalence of rumors of all types in the investment community, and how quickly rumors can spread, a key challenge to the SEC in any investigation will be to determine who is responsible for disseminating false rumors and whether those persons acted intentionally and with knowledge that the rumors were false. 
    
     
  • At the same time, the SEC’s focus on firm procedures indicates that the SEC will be looking to bring enforcement actions not only against individuals who are responsible for creating or disseminating false rumors, but also against any broker-dealers or investment advisers in the rumor chain that the SEC determines had lax oversight. 
    
     
  • Complicating matters is the fact that, on September 18, New York Attorney General Andrew Cuomo announced his own investigation into allegations of short selling in financial securities based upon false information. NYAG involvement not only increases pressure on the SEC to bring cases in this area, but is also a direct and formidable threat to the individuals and entities under scrutiny. Unlike SEC Enforcement staff, New York’s Assistant Attorneys General have considerably fewer levels of bureaucracy to wind through before they can bring a case - as they have repeatedly demonstrated in matters involving market timers, insurance brokers, lenders, ratings agencies, and purveyors of auction-rate securities, to name a few. Contrary to popular belief, Section 352 et seq. of NY General Business Law (aka the “Martin Act”) is not without its jurisdictional limitations and defenses, but it is nonetheless a potent starting point for the NYAG. Subpoenas issued thereunder must be handled with considerable caution.
    
     
• “Naked” short selling
  
  
  • SEC Chairman Christopher Cox has observed that naked short selling can “turbocharge” false rumor/manipulation schemes. (LINK) 
    
    
    • Generally, the SEC defines naked short selling as “abusive” when the seller does not have shares available for delivery and intentionally fails to deliver stock within the standard three-day settlement cycle.
      
       
  • On September 18, 2008, the SEC adopted Rule 10b-21, which had been proposed in March 2008 to address the problem of short sellers who deceive broker-dealers or others about their intention or ability to deliver securities in time for settlement. (LINK) The rule formed part of the SEC’s response, in the current financial crisis, to concerns about possible false rumors and abusive naked short selling of financial institutions and other issuers. 
    
     
    • Rule 10b-21 prohibits any person from submitting an order to sell an equity “if such person deceives a broker or dealer, a participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.” (LINK)
      
       
    • In adopting the rule, the SEC noted that while, in its view, naked short selling as part of a manipulative scheme was already prohibited under general antifraud provisions, Rule 10b-21 is intended to highlight the specific fraud liability of persons who deceive other participants about their intention or ability to deliver securities in time for settlement.

Of course, when short selling is facilitated by deceptive practices – such as intentionally spreading false rumors or misleading other participants about an intention to deliver stock – there is little doubt that the SEC can bring a case for securities fraud.   Another example of deceptive practices might be the use of nominee accounts or similar efforts to disguise the identity of the short seller.  But what if short selling is done in the open, with no accompanying acts of deception, albeit in large amounts and with the intent to drive a company’s stock price down? 

• The SEC takes the position that even open trading, when done for a manipulative purpose (so-called “open market manipulation”), is fraudulent.   See, e.g., SEC v. Masri, 523 F. Supp. 2d 361 (S.D.N.Y. 2007).  Thus, the Division of Trading and Markets has cautioned that “short sales effected to manipulate the price of a stock are prohibited” as an “abusive” short sale practices. (LINK)
  
   
• Courts have taken varying positions on whether “open market manipulation,” without other deceptive conduct, can give rise to a cause of action.   However, in a recent opinion dealing with aggressive short selling by purchasers of “toxic convertible” securities, the U.S. Court of Appeals for the Second Circuit held that “short selling – even in high volumes – is not, by itself manipulative.  … To be actionable as a manipulative act, short selling must be willfully combined with something more to create a false impression of how market participants value a security.”  ATSI Communications, Inc. v. Wolfson, 493 F.3d 87 (2d Cir. 2007).

Given the Second Circuit precedent, in any future cases directed at aggressive short selling, the SEC will likely seek to allege other deceptive conduct in addition to short sales.   However, in light of the SEC’s need to demonstrate a strong response to the current crisis, the Commission can also be expected to press its theory that short selling, even if unaccompanied by any other deceptive practices, is unlawful if done for the purpose of depressing a company’s stock.

• Email This
• Print
• Comments
• Trackbacks

Perhaps not surprisingly, the FBI and DOJ have joined a host of other federal and state authorities and opened investigations stemming from the credit crisis.   On September 29, 2008, both Freddie Mac and Fannie Mae separately announced that, in connection with a federal criminal investigation regarding accounting, disclosure and corporate governance matters, they had received federal grand jury subpoenas from the United States Attorney’s Office for the Southern District of New York.  Both have pledged cooperation. Reportedly, the FBI is also looking into Lehman Brothers, AIG and 22 other institutions. 

The opening of such investigations was predictable.   Less predictable is whether DOJ will find evidence of criminal activity — particularly in an area as complex as mortgage financing. 

The New Guidelines
Leaving aside the likely results of these probes, the investigations come at something of a turning point for DOJ.  A little over a month ago, on August 28, DOJ revised its Principles of Federal Prosecution of Business Organizations (the “Principles”), which are part of the United States Attorneys’ Manual (“USAM”), the guidebook for all federal prosecutors.   (See the DOJ’s press release; the relevant USAM provisions can be found here.)

In the revision (henceforth the “2008 Principles”), DOJ retreated from its widely-criticized position that federal prosecutors could demand that corporations — and by extension, individuals — waive the attorney-client privilege and work-product protection as a necessary precondition in earning credit for cooperating with DOJ, a point of major dispute with the legal community at large.   This policy change, likely forced by Congress’ threats to mandate just such a reversal, is significant.  Most critically, in cases handled by DOJ, the new policy largely re-establishes the right of a corporation to confer with its attorneys without fear that the attorney-client privilege which protects those communications from disclosure will be sacrificed.  That said, it remains to be seen how the changed guidance will work in practice as these new Principles are tested in the crucible of high-profile investigations growing out of the current crisis. 

Federal prosecutors have broad discretion in deciding whether to charge a corporate entity with a crime.  Companies may be held criminally liable for the conduct (or omissions) of their agents committed within the scope of their duties and intended, at least in part, to benefit the corporation.  Thus, as a matter of law, the crimes of any employee in the organization, regardless of whether he or she occupies a high or low position on the organization chart, may be attributable to the company and the company can be charged criminally for them.  Whether DOJ seeks to bring a federal criminal case against the corporation in circumstances like these is a matter of discretion, which in turn depends upon the corporation’s cooperation as measured under the Principles.

The 2008 Principles contain several significant changes to DOJ policy guidance on charging companies with criminal conduct. 

• Prohibition on requesting privilege waivers.   The 2008 Principles no longer require waiver of the attorney-client privilege or work-product protection to qualify for cooperation credit.  Indeed, the 2008 Principles prohibit prosecutors from requesting attorney-client and work-product waivers.  But they do permit those prosecutors to request that corporations produce facts, however they are gathered; “credit for cooperation will not depend on the corporation’s waiver of attorney-client privilege or work-product protection, but rather on the disclosure of relevant facts.”  In other words, the 2008 Principles recognize that companies may voluntarily choose to waive the work-product and attorney-client privilege protections in providing facts, but they are not required to do so, and prosecutors cannot expressly seek an attorney-client waiver in making such a request. 
  
   
• Indemnification of employees.  The 2008 Principles provide that prosecutors generally should not consider whether corporations indemnify their employees for legal fees incurred in defending themselves in criminal investigations or prosecutions, nor should prosecutors ask corporations to refrain from advancing attorney’s fees or providing counsel to employees under investigation or indictment.  Such practices should only be questioned by prosecutors if they are part of an effort to obstruct justice – such as “if fees were advanced on the condition that an employee adhere to a [false] version of the facts.”  
  
   
• Joint defense agreements.   The 2008 Principles state that a corporation’s involvement in a joint defense agreement — an agreement by which potential defendants share information regarding the defense without losing the attorney-client privilege protecting the shared information from disclosure — “does not render a corporation ineligible to receive cooperation credit, and prosecutors may not request that a corporation refrain from entering into such agreement.”  The 2008 Principles add, however, that the government may properly request the corporation not share “sensitive information about the investigation that the government provided to the corporation” with others to get cooperation credit. 

It is unclear whether the sometimes fine line between a government request for facts and one that seeks a waiver of the privilege will be adhered to in practice by prosecutors.   In practical terms, companies and their lawyers involved in investigations into the credit crisis must be careful to preserve the attorney-client privilege and work-product protections, as the 2008 Principles put the burden of preserving these confidences on them.  Doing so may be critical – waiver of the privilege in producing information to the government in a criminal investigation is almost always considered by courts to be a waiver as to all other parties, including parties in civil actions.  Corporations facing criminal exposure are thus well advised to consult as early as possible with qualified criminal counsel to assist them in navigating these still-dangerous waters. 

• Email This
• Print
• Comments
• Trackbacks

By: Philip J. Morgan, Robert V. Hadley

A hallmark of enforcement by the U.K. Financial Services Authority (the “FSA”) in 2008 has been the effort to establish that abusive behavior is likely to trigger severe personal consequences - so-called “credible deterrence.”  The FSA is now spreading the message that it is “getting tough” and intends to increase its focus on deterrence through enforcement action.

The FSA has been saying for some time that it intends to boost credible deterrence and engage senior management in particular in relation to its strategic priorities of combating market abuse and insider dealing by three strategies: higher financial penalties; greater focus on enforcement actions against individuals rather than or as well as firms; and the prosecution of criminal cases.  Yet many have wondered when the rhetoric would be matched by action.  In all of 2007 the FSA imposed just one fine for abuse-related activity.  By the start of 2008 the FSA had brought one successful criminal prosecution since its establishment under the current regulatory regime on 1 December 2001.  It had prosecuted nobody for the criminal offence of insider dealing.

Now, things appear to be starting to change. The FSA has said that in order to achieve its aim of credible deterrence it must prosecute “a steady stream” of criminal cases.  Thus, in January of this year the FSA launched its first criminal prosecution for insider dealing against two individuals, one of whom was an in-house counsel.  In July it commenced two more prosecutions, one against a former Cazenove partner. There are said to be several others in the pipeline.

Also, on July 29, 2008, an extensive dawn raid operation was mounted on various addresses by the FSA under search warrants.  Eight individuals were arrested. The FSA said that this was in connection with “a major ongoing investigation into insider dealing rings.” The FSA does not comment on ongoing investigations, but this was a further clear demonstration of intent.

Individuals, and especially senior management and others in the regulated sector, can be in no doubt that there is at least some risk of criminal prosecution for insider dealing and other market manipulation offences. The risk is not merely of financial penalty imposed on their firm, or even on them personally.  Certainly no one can any longer say that the FSA has never prosecuted anyone for such activities.  The FSA’s aim is that any person with access to inside information or other opportunity to abuse the market should believe that these criminal cases are the first of its “steady stream,” and to think clearly that that is not where they wish to swim.

The FSA also will point to other recent actions as evidence of its new, more aggressive posture toward enforcement.

In the past two months, the FSA fined Credit Suisse £5.6 million for the mismarking of certain positions resulting in an overstatement in published accounts corrected some eight days later, and fined a GE Money mortgage brokerage operation £1.1 million for defective systems and controls leading to its not accounting correctly for customer funds, so that, for example, mortgages were overpaid on redemption and clients’ money was not applied to their mortgage accounts promptly or accurately (both fines imposed after the FSA acknowledged the full cooperation of the firms and after applying the 30 percent reduction for settling at an early stage of the enforcement process).  These cases are examples of the higher financial penalties that the FSA intends to seek.

The FSA fined Land of Leather Limited in May in relation to inadequate systems and controls to prevent the sale of Payment Protection Insurance which was unsuitable for customers’ needs, but will stress that it also fined the company’s Chief Executive £14,000 (after a 30 percent early settlement reduction) in respect of the same matter. This shows the FSA’s willingness to pursue senior management on the basis of senior management’s responsibility for a firm’s regulatory compliance.

Similarly the FSA extracted an undertaking from Mr. Steven Harrison, an investment manager at a hedge fund, effectively that he stay out of the financial services industry for 12 months (in addition to a financial penalty of £52,500 - after the 30 percent early settlement reduction).  The allegation was market abuse in the sense of instructing colleagues to purchase certain bonds while in possession of inside information.  The final notice acknowledges that Mr. Harrison’s conduct was not deliberate in the sense that he did not consider at the time that he had inside information, but the FSA’s position was that he should have recognized that fact.  The FSA thus intends to promote deterrence not only by fining individuals, but also by affecting their continued ability to earn their livelihood in the financial services sector.

• Email This
• Print
• Comments
• Trackbacks