Legal Developments in Securities Law

Dodd-Frank Update: New Private Fund Rules Released
Recently, the Securities and Exchange Commission (“SEC”) adopted final rules concerning the registration of advisers to private funds. Some of these rules varied greatly from the initial proposed rules. In the Release by the SEC and the Commodity Futures Trading Commission (“CFTC”), it was clear that many changes addressed commenters’ concerns with the proposed rules and their viability or effectiveness at achieving the rule’s purpose. Many commenters expressed concerns with certain fund advisers’ ability to provide reliably accurate data within a short deadline.

A number of these provisions are important to private fund advisers. To begin with, private fund advisers are divided into two general groups – a large private fund adviser or a smaller private fund adviser. Large private fund advisers are divided as follows:

  • Large Hedge Fund Advisers – $1.5 billion in hedge fund assets under management,
  • Large Liquidity Fund Advisers – $1 billion in combined liquidity fund and registered money market fund assets under management, and
  • Large Private Equity Fund Advisers – $2 billion in private equity fund assets under management.

Smaller private fund advisers are all other advisers, but note that not all smaller private fund advisers may be required to file the Form PF, if they have less than $150 million in private fund assets under management. Depending on the fund adviser’s classification, the deadlines to file the Form PF and the portions of the Form that must be completed will vary. The Form PF is a new reporting form developed to provide regulators with private fund information; notably, this Form will receive confidential treatment by the SEC and CFTC, although its contents may be disclosed to other Federal departments, agencies or self-regulatory organizations, in addition to the CFTC and FSOC. The Form PF is divided as follows:

  • Section 1: Information regarding the adviser’s identity and assets under management; limited information regarding the size, leverage and performance of all private funds subject to the reporting requirements, and; requires additional basic information regarding hedge funds.
  • Section 2: Aggregate information about the hedge funds the adviser manages; additional information about any hedge fund it advises that has a net asset value of at least $500 million as of the end of any month in the prior fiscal quarter.
  • Section 3: Information regarding the fund’s portfolio valuation and its valuation methodology, as well as the liquidity of the fund’s holdings; information regarding whether the fund, as a matter of policy, is managed in compliance with certain provisions of rule 2a-7 under the Investment Company Act.
  • Section 4: Information regarding the activities of private equity funds, certain of their portfolio companies and the creditors involved in financing private equity transactions.

Of course, the requirements and questions within each section are more detailed than the overview provided above, but private fund advisers should prepare themselves for the type of information that will be requested of them.

The deadlines to submit Form PFs to the SEC are categorized as follows:

  • Smaller Private Fund Advisers: Within 120 days after the end of the fiscal year. Reporting occurs on an annual basis. The previous proposed deadline provided 90 days.
  • Large Private Equity Advisers: Within 120 days after the end of the fiscal year. Reporting occurs on an annual basis. The previous proposed deadline provided only 15 days.
  • Large Hedge Fund Advisers: Within 60 days from the end of each fiscal quarter. Reporting occurs on a quarterly basis. The previous proposed deadline provided only 15 days.
  • Large Liquidity Fund Advisers: Within 15 days from the end of each fiscal quarter. Reporting occurs on a quarterly basis.

In addition to the new deadlines, the rules also made clear which portions of the Form PF each type of private fund adviser must complete, as follows:

  • Smaller Private Fund Advisers: Must provide only basic information regarding their operations and the private funds they advise, including their performance, leverage and investor data (all or portions of Section 1 of Form PF).
  • Private Equity Advisers: Must submit information on Form PF regarding the financing and activities of these funds in section 1 of the Form, and large private equity advisers are required to provide additional information in section 4 of the Form.
  • Hedge Fund Advisers: Must submit information on Form PF regarding the financing and activities of these funds in section 1 of the Form, and large hedge fund advisers are required to provide additional information in section 2 of the Form.
    • Under the rules, to be classified as a hedge fund, the private fund must have one of the following three characteristics:
      • (a) a performance fee that takes into account market value (instead of only realized gains)
      • (b) high leverage; or
      • (c) short selling.
  • Liquidity Fund Advisers: Must submit information on Form PF regarding the financing and activities of these funds in section 1 of the Form, and large liquidity fund advisers are required to provide additional information in section 3 of the Form.

Obviously, the above summary is provided as an indication of the requirements private fund advisers will face in the near future (as early as June 15, 2012 for some advisers). Private fund advisers should prepare for compiling, reviewing and filing the Form PF, and contact an experienced attorney if you have any questions.

Legal Developments in Securities Law

Federal Judge Critiques SEC’s Proposed Settlement with Citigroup
Could Force SEC to be More Aggressive in the Future
This blog post references Peter Latman’s NY Times article, “Judge in Citigroup Mortgage Settlement Criticizes S.E.C.’s Enforcement,” found here.

Yesterday, the Securities and Exchange Commission (“SEC”) was asked by Judge Rakoff to defend its proposed settlement with Citigroup Global Markets, Inc. (“Citigroup”) based on its structuring and marketing of a largely synthetic collateralized debt obligation. Specifically, the SEC alleged that Citigroup negligently misrepresented key deal terms, such as its own financial interest in the transaction and that Citigroup had exercised significant influence over the selection of assets.

Judge Rakoff questioned the SEC’s decision to accept a settlement of $285 million, while indicating that the SEC estimated that investors lost close to a total of $700 million in the investments. Judge Rakoff was equally inquisitive about the SEC’s injunction, to bar Citigroup from violating securities laws in the future. Notably, the Judge asked, “Why do you ask for an injunction when you never use it?” The SEC can file civil contempt proceedings if an organization or individual under an injunction not to violate securities laws in fact violates securities laws again in the future. Notably, no such charges have been brought in the last ten years. Such injunctive relief has been the subject of ridicule in the past – it is axiomatic that an organization or an individual is prohibited by law from violating securities laws. As is standard with settlements with the SEC, the entity or individual involved does not admit or deny any wrongdoing with regard to the allegations. Judge Rakoff likewise questioned Citigroup’s unwillingness to admit liability in this matter.

Some may remember that Judge Rakoff likewise questioned the SEC’s proposed settlement with Bank of America concerning whether Bank of America misled investors about its acquisition of Merrill Lynch. There, Judge Rakoff initially rejected a $33 million settlement proposal, and later reluctantly accepted a revised settlement for $150 million.

Judge Rakoff’s refusal to “rubber stamp” the SEC’s proposed settlements with large financial institutions could have potential ramifications on the settlements the SEC negotiates in the future. Judge Rakoff’s comment, “I won’t be cute and ask what percentage of Citigroup’s net worth is $95 million because I do not have a microscope with me,” indicates that this type of scrutiny is perhaps reserved for larger financial institutions, rather than their smaller counterparts or even individuals. Seemingly, given the alleged violations involved and the impact on the shareholders involved, the settlement amount was not proportionate to the harm based on Judge Rakoff’s observation. Although the SEC may adjust its disgorgement figures or civil penalties based upon a respondent’s showing of its/his/her financial inability to pay, an entity like Citigroup clearly does not face such a burden. As a result of Judge Rakoff’s refusal to acquiesce to whatever settlement proposal the SEC sets forth, the SEC may play hardball with large financial institutions to avoid future judicial scrutiny. Further, it is conceivable that the SEC may file a civil contempt proceeding the next time that an institution that has been barred from violating securities laws, violates securities laws. Although the SEC has not done so in at least ten years, pressure from the public may mount if an entity like Citigroup or Bank of America is accused of violating securities laws again. It seems unlikely, however, that respondents would be forced to admit liability as a condition of settlements – the practice of neither admitting nor denying liability is not only standard among settlements with the SEC, but in the general practice of law.

So-called smaller actors, such as smaller entities or individuals, may nonetheless find the SEC requesting large settlement amounts, especially given the impact, severity or frequency of their alleged securities law violations. The SEC takes into account a number of factors when determining an appropriate civil penalty, such as the egregiousness of the defendant’s actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant’s assurances against future violations, the defendant’s recognition of the wrongful nature of his conduct, and the likelihood that his occupation will present opportunities for future violations. Think of an individual like Raj Rajaratnam, who was recently ordered to pay a total of $156.6 million in fines and disgorgement, an amount that Judge Rakoff again questioned given Rajaratnam’s net worth and the fact that the civil penalty was designed, in Judge Rakoff’s words, “to make such unlawful trading a money-losing proposition not just for this defendant, but for all who would consider it.”

Further, although the SEC may request injunctive relief that an individual be barred from violating securities laws in the future, that individual may also be barred from serving as a director of a public company, from working in the securities industry, or from participating in the issuance of certain kinds of securities offerings, to name but a few examples. Judge Rakoff’s remarks should serve as a wake-up call for large financial institutions, but others are by no means less vulnerable to the range of consequences the SEC could request.

Legal Developments in Securities Law

SEC Dodd-Frank Whistleblower Claim Update
The SEC recently released its Fiscal Year 2011 Annual Report on the Dodd-Frank Whistleblower Program, found here. The report noted that 334 whistleblower tips were received in only the first seven weeks of the program. The most common tips were concerning market manipulation, corporate disclosures and financial statements, and offering fraud.

Tips were received from 37 states, China, the United Kingdom, and a number of other foreign nations. In the United States, whistleblowers from California and New York submitted the most tips.

It is not surprising that no awards have been allocated to whistleblowers yet, but whistleblowers who submitted claims should pay attention to the SEC’s procedure for claiming an award to which they may be entitled. If an action results in an entry of final judgment that exceeds $1 million, the whistleblower may be entitled to an award (see our previous blog post). After the final judgment on an action is entered, the Office of the Whistleblower will publish a Notice of Action on the SEC’s website. At this time, the whistleblower will have 90 days to apply for his or her award by completing the Form WB-APP. The SEC noted in its report that they may eventually provide individual notices to whistleblowers who may have contributed to the successful final judgment, but for the time being, whistleblowers should pay careful attention to the Notices of Action posted on the SEC’s website.

Legal Developments in Securities Law

Madoff Employee Admits Guilt : Three Simple Ways to Avoid Facilitating Securities Fraud at Your Job
Recently, a former trader at Bernard Madoff’s investment firm admitted to creating fictitious, backdated trades in Madoff’s notorious Ponzi scheme. Although certain types of securities fraud violations may be clear to an employee, such as being asked to falsify documents that are sent to investors, other requests by an employer may fall into a grey-area. How can an employee tell whether he or she is aiding the company in some way that enables it to carry out a massive fraud on its investors? Each individual case will vary, but here are some guidelines you can use to help you address this inquiry:

1. React immediately to wrongdoing.
As mentioned above, if you’re being asked to falsify documents or if you’re getting payments for turning a blind eye, it’s very clear that there is wrongdoing, and you are involved in it. Even if you are not the mastermind behind the fraud, benefiting from it or aiding it will nonetheless implicate you. If you discover anything that clearly evidences that there is wrongdoing, your first step should be to take action to prevent the fraud from continuing. See #3 below for more information on what you can do.

2. Trust your intuition.
If you feel that something isn’t quite right, there may be something more there. For example, if the company struggles to operate profitably despite advertising consistent profits, it’s possible the company may be intentionally misleading investors. Or, you may notice an accounting error. If you notice an error, you may want to bring it to the attention of the individual who can correct the error, but it may also help to speak with your company’s compliance department or even leave an anonymous tip on the company’s hotline.

3. Know your options.
Your company may have a compliance department that can address any concerns you may have. If you work at a smaller company, they may have guidelines on how to report any concerns you may have. If you work at a company with no compliance department, anonymous tip hotline or other guidelines to follow, you can consider filing a Tip, Complaint or Referral with the SEC through its new Dodd-Frank Whistleblower Program. Indeed, the SEC’s Whistleblower Program may even be your first option, depending on certain prerequisites for certain types of employees. If your attempts at resolving the issue within the company are unsuccessful, the Whistleblower Program is a great follow-up option, as well. Remember, under the SEC’s new program, whistleblowers can actually receive a reward for their cooperation, as detailed in our previous blog posts, here and here. Of course, each individual case may be different, and the advice of an experienced attorney can be valuable if you are unsure of what you can do. Under the federal securities laws and numerous state laws, whistleblowers who are fired in retaliation for reporting wrongdoing are legally protected and may be entitled to damages or even reinstatement to their prior positions.

Legal Developments in Securities Law

SEC Seeks to Raise Potential Civil Penalties
Earlier this week, the SEC’s chairperson, Mary Schapiro, sent a letter to Senators Jack Reed and Mike Crapo urging that Congress change the current rules on how the SEC can fine individuals and companies and to plead for greater maximum civil penalties.

Currently, the SEC can impose up to $150,000 per violation as a civil penalty against an individual, but the SEC has requested that the potential fine be increased to up to $1 million. For an entity, the civil penalty can be up to $750,000 under current rules, but Chairman Schapiro would like that potential penalty to go up to $10 million.

Other changes proposed included the ability to calculate the fine as three times the disgorgement figure, which represents the profits that were made by the accused. Currently, another method by which the SEC calculates a civil penalty is a fine that is equal to the disgorgement figure. Further, the Chairman proposed basing the fine on the amount of investor losses, rather than being based on the disgorgement figure, which could be significantly lower. Finally, the Chairman also asked that penalties be increased for repeat offenders. The SEC’s ability to recover from defendants may provide a deterrent to future securities violations, but by the same token, defendants would still be able to demonstrate their financial inability to pay a civil penalty.

It seems apparent that the Chairman’s suggested increases would increase the penalties for entities, more so than for individuals. While the proposed maximum civil penalty for individuals is five times the current maximum, the proposed maximum fine for entities is ten times greater than the current maximum. Given the recent issues with the Citigroup settlement that were raised by Judge Rakoff and the anti-Wall Street sentiment that has developed across the country, it is not surprising that the SEC would react in this way. To truly deter financial entities from committing securities violations in the future, arguably, any potential punishment would have to outweigh the potential gain to the entity, if the entity operates purely on a profit-seeking basis. That sentiment certainly seemed to be echoed by Judge Rakoff last month.

Chairman Schapiro’s staff is in the process of preparing draft legislation for legislators to consider. In the meantime, this letter from Chairman Schapiro is likely just another step to demonstrate the SEC’s willingness to aggressively pursue potential securities law violations, and more changes from the agency are likely in the future.

Legal Developments in Securities Law

SEC Investigations: What Happens at each Step of an Investigation?
In the news recently, many different stages of an SEC investigation have been reported on – the city of Miami and Miami-Dade county received subpoenas which asked for communications with executives and representatives of the Marlins, a Major League Baseball team, and Harbinger Capital and Phillip Falcone received Wells Notices from the SEC. Individuals have asked if the subpoena means that the Marlins were involved in some sort of securities fraud or if a Wells Notice means the SEC believes you committed securities fraud. To clarify any misunderstandings, here is an overview of the SEC’s investigatory process.

Step One: The Tip
The SEC first has to have a reason to suspect that violations of the securities laws have taken place. The SEC states that, “The Division obtains evidence of possible violations of the securities laws from many sources, including market surveillance activities, investor tips and complaints, other Divisions and Offices of the SEC, the self-regulatory organizations and other securities industry sources, and media reports.” See here. For example, the SEC staff regularly reviews disclosure documents filed by companies. As we’ve previously blogged, the SEC also encourages whistleblowers to come forward with information concerning potential violations by offering the chance for a large bounty. Whistleblowers can include employees of companies or even investors in certain securities who have a sense that securities law violations may have taken place. This preliminary “tip” will cause the SEC to try to determine the potential violations that took place and to decide whether or not to open up an investigation into the matter – this is a question that is decided privately within the SEC. Not all “tips” result in an investigation.

Step Two: The Investigation
When the SEC decides to conduct an investigation, the SEC uses many means to determine whether the investigation should result in a case in federal court or an administrative action. The SEC uses informal inquiries, interviews with witnesses, examinations of brokerage records and trading data, and other methods to develop the facts during an investigation. SEC investigations are private, and may be formal or informal. During the informal stage, SEC staff may ask individuals to voluntarily provide the SEC with information. To obtain a Formal Order of Investigation, the staff requests authorization from the commissioners in order to conduct a formal investigation. At this stage, individuals and entities may receive subpoenas for documents and testimony, as permitted by the Formal Order of Investigation, which is not a matter of public record. Subpoenas for documents are often very broad and may require the production of a large number of documents. This is merely an investigatory stage in the process – the receipt of an SEC subpoena does not necessarily indicate that the SEC suspects that the individual or entity was involved in securities fraud. The SEC is merely gathering information to analyze in making a determination as to whether to pursue further action.

Step Three: Wells Notice
At the conclusion of the investigation, the SEC staff will decide whether or not to recommend to the commissioners that the SEC institute an enforcement action or federal case. If the staff decides to recommend enforcement, the potential respondent/defendant receives a “Wells Notice,” which apprises the individual or entity of the alleged violations of securities laws it intends to pursue. The potential respondent/defendant then has the opportunity to submit a “Wells Submission” – which serves to try to persuade the staff that an enforcement action is not warranted. After considering the Wells Submission, the staff can choose to conclude the investigation or to submit its recommendation for an enforcement action, along with the Wells Submission, to the commissioners. The Commission can authorize the staff to file a case in federal court or bring an administrative action. Often, cases will settle outside of such proceedings, but in some cases, the SEC proceeds with an enforcement action.

Step Four: Enforcement Action
The SEC may proceed in federal court or with an administrative action. The Federal Rules of Civil Procedure do not apply in administrative actions and appeals go to the commissioners, but the SEC can seek a civil penalty based on a defendant’s pecuniary gain by filing a civil action only in federal court. At this stage, the SEC will pursue sanctions in the form of monetary penalties, disgorgement of ill-begotten gains, cease-and-desist orders or injunctions, officer-director bars or penny stock bars, among others.

If you’re unsure of where you might fit within the SEC’s process, be sure to contact an experienced attorney. Proper representation and cooperation with the SEC could help you avoid unnecessarily proceeding through an administrative proceeding or civil case in federal court.

Legal Developments in Securities Law

Update: SEC Appeals Judge Rakoff’s Ruling Denying Proposed Settlement
One of our earlier blog posts referenced Judge Rakoff’s criticism of the SEC’s proposed settlement with Citigroup – found here. Unsurprisingly, Judge Rakoff rejected the parties’ proposed settlement. The SEC has now filed an appeal, citing legal error and claiming that, “We believe the district court committed legal error by announcing a new and unprecedented standard that inadvertently harms investors by depriving them of substantial, certain and immediate benefits,” as set forth in a statement by Robert Khuzami, the S.E.C.’s director of enforcement (see the New York Times article on this issue here).

The SEC’s appeal is certainly not unprecedented, as the New York Times notes that the agency has indeed appealed such rulings in the past, and in fact won such an appeal in S.E.C. v. Randolph. The SEC’s decision to appeal Judge Rakoff’s decision, which reasoned that the proposed settlement simply was not in the public interest and that more facts were necessary to approve such a settlement, suggests a reluctance to fight Wall Street. One could reason that the SEC may treat larger institutions that are repeat offenders, like Citigroup, less harshly than the “little guys,” or individuals and small companies involved in SEC enforcement actions.

Certainly, the resources involved in litigating against a large institution like Citigroup in federal court are not minimal, but given that investors experienced over $700 million in losses, a settlement amount of $285 million concerning charges of securities law violations pales in comparison to the harm caused. By comparison, the “little guys” cannot afford lengthy litigation against the SEC, and perhaps the SEC can use that as leverage to obtain a settlement that fully disgorges the defendant’s ill-begotten gains. Settlements, however, do involve a case of give and take – the SEC may not get the full amount requested and the defendant agrees to a sum that may be lower than the potential outcome in litigation. With an institution like Citigroup, the SEC may be additionally motivated to settle the matter more expeditiously to avoid a lengthy trial and potential failure in court. With the “little guys,” the SEC holds the upper hand, and it’s hard to imagine a scenario where the SEC would appeal a Judge’s ruling rejecting a settlement with such an individual.

It is no surprise that the reaction among members of the public toward the SEC has been one of outrage concerning the SEC’s decision to appeal Judge Rakoff’s decision. Dennis M. Kelleher, of Better Markets, Inc., wrote in the Huffington Post:

No one should be surprised that the risk-adverse, Wall Street friendly SEC chose not to litigate against Citigroup for pocketing more than $600 million from its $1 billion fraudulent subprime mortgage scheme that cost its customers more than $700 million. Instead, the SEC decided to litigate against the one federal judge who had the audacity to scrutinize their proposed settlements. As the Wall Street Journal headline correctly captured it, “SEC Cops Want to Fight U.S. Judge.”

Ironically, in the eyes of the SEC, Judge Rakoff is a repeat offender (first, Bank of American and now Citigroup!), but Citigroup is literally a repeat offender, having been toothlessly sanctioned by the SEC 5 times in the last 8 years for violations of the securities laws. Judge Rakoff had the nerve to ask the SEC what was the point of slapping their wrist one more time given that the prior five slaps appeared not to make much of an impression. (Such repeated toothless “sanctions” is common for the SEC.)

View Mr. Kelleher’s article here. The Wall Street Journal’s Law Blog featured a piece by Neal Lipschutz that stated:

Here’s a quote from Judge Rakoff’s decision, which I have cited before, that gets to the crux of the matter. “An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous … If its deployment does not rest on facts – cold, hard, solid facts, established either by admissions or by trials — it serves no lawful or moral purpose and is simply an engine of oppression.”

Khuzami said in part Thursday: “In fact, courts have routinely approved settlements in which a defendant does not admit or even expressly denies liability, exactly because of the benefits that settlements provide.”

But just because something happens a lot doesn’t mean it’s correct. Here’s hoping the power of Rakoff’s apparently singular argument sets a new precedent.

The Wall Street Journal Law Blog post can be found here.

Although it is certainly true that settlements routinely include language in which the defendant neither admits nor denies liability, it appears that perhaps Judge Rakoff took issue with that language in the Citigroup proposed settlement because the institution has been sanctioned multiple times in the last eight years. If the “little guys” commit multiple securities law violations, they would face injunctions and bars from practicing their profession which hit them much harder than a nominal monetary settlement for a large institution. If a large institution can pay only a nominal settlement without admitting or denying liability, what would prevent that institution from carrying on illegal activity that results in a profit? In this situation, Citigroup allegedly made around $600 million from its fraudulent scheme, but tried to settle the matter for $285 million – a $315 million profit. Even if the SEC’s recent actions are not out of the ordinary, appealing Judge Rakoff’s decision has not improved the agency’s image.

Legal Developments in Securities Law

Dodd-Frank Update: Final Rule on Accredited Investor Standard
This week, the SEC released a final rule on the net worth standard for accredited investors. The accredited investor standards, in Rules 215 and 501 under the Securities Act of 1933, are important to determine whether certain exemptions from registration apply under the securities laws. This is important with the following provisions:

  • Sec. 4(5) of the Securities Act: Transactions involving offers or sales solely to one or more investors are exempt from registration if the aggregate offering price does not exceed $5 million, there is no advertising or public solicitation and the issuer files notice with the SEC;
  • Reg D of the Securities Act: Under the safe harbor provisions of Rule 505 or 506, the issuer is exempt from certain information requirements if sales are made only to accredited investors, and sales to such investors do not count toward the 35 purchaser limit under these safe harbor provisions. Also, there is no sophistication requirement under Rule 506 for accredited investors.

Under Section 413(a) of Dodd-Frank, the SEC was required to make certain changes to the existing standard. Of greatest significance, the SEC has finalized the rule that now eliminates an individual’s primary residence as an asset in the calculation of his net worth. Consistent with this approach, indebtedness secured by the person’s primary residence is not counted as a liability, unless the indebtedness exceeds the net worth of the property, in which case the excess indebtedness is treated as a liability. Notably, the indebtedness secured by the primary residence contains a 60 day period, where any incremental increase in the amount of debt secured by a primary residence in the 60 days before the time of the net worth calculation of an individual generally will be included as a liability. This provision was included to prevent people from manipulating the rules by taking advantage of positive equity in their primary residence for the purposes of the net worth calculation.

If individuals previously qualified as an accredited investor, the new calculation of net worth will not apply to the purchase of securities in connection with a right to purchase such securities if:

  • The individual had the right to purchase the securities at issue on July 20, 2010;
  • The individual qualified as an accredited investor at the time the individual acquired the right to purchase the securities; and
  • The individual held securities of the same issuer, other than the right to purchase securities of the issuer, on July 20, 2010.

The SEC defined the types of rights to purchase securities it envisioned as “[T]he exercise of statutory rights, such as pre-emptive rights arising under state law; rights arising under an entity’s constituent documents; and contractual rights, such as rights to acquire securities upon exercise of an option or warrant or upon conversion of a convertible instrument, rights of first offer or first refusal and contractual pre-emptive rights.”

The SEC noted that some of the costs involved will include potentially estimating a fair market value of the individual’s primary residence for purposes of calculating whether indebtedness exceeds the value of the home and making additional calculations if the individual increases indebtedness that is secured by the primary residence in the 60 days prior to the net worth calculation.

Further rulemaking on this issue is expected – Section 415 of the Dodd-Frank Act requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” The SEC will use this information in future rulemaking on this issue. It is important for individuals who hope the take advantage of the exemptions related to the accredited investor standard to retain counsel with experience in this field and who will be able to offer advice on any future changes in these provisions.

Legal Developments in Securities Law

A Look Back at 2011: The Biggest Securities Law News of the Year
2011 was a big year in securities law – from the Galleon Group insider trading convictions to the beginning of the SEC’s whistleblower program under Dodd-Frank. Here, we’ll review the top five securities law stories from 2011.

5. Judge Rakoff Challenges Settlements Made “Without Admitting or Denying Wrongdoing”
In 2010, Judge Rakoff first questioned the SEC’s proposed settlement of $33 million with Bank of America for misleading shareholders concerning its acquisition of Merrill Lynch. In 2011, Judge Rakoff started off the year by expressing his distaste for settlements between the SEC and wrongdoers that were made “without admitting or denying wrongdoing,” a standard practice in the industry. In the SEC’s settlement with Vitesse Semiconductor and three former executives over improper accounting of revenue and backdating of stock options, Judge Rakoff wrote:

The result [of neither admitting nor denying wrongdoing] is a stew of confusion and hypocrisy unworthy of such a proud agency as the S.E.C. The defendant is free to proclaim that he has never remotely admitted the terrible wrongs alleged by the S.E.C.; but, by gosh, he had better be careful not to deny them either (though, as one would expect, his supporters feel no such compunction). Only one thing is left certain: the public will never know whether the S.E.C.’s charges are true, at least not in a way that they can take as established by these proceedings.

This might be defensible if all that were involved was a private dispute between private parties. But here an agency of the United States is saying, in effect, “Although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.”

In the Vitesse Semiconductor settlement, however, the Judge found that the amount was fair, reasonable and in the public interest. See article here. Later in 2011, however, Judge Rakoff outwardly rejected the SEC’s proposed settlement of $285 million with Citigroup, which represented only a fraction of the losses involved (the SEC alleged that Citigroup bet against its customers in housing related investments and made profits of $160 million while the customers lost more than $700 million). Judge Rakoff again questioned why Citigroup could get away with neither admitting nor denying liability, and even questioned the SEC’s practice of obtaining injunctions against defendants, prohibiting them from violating securities laws in the future (Judge Rakoff also questioned the factual basis for the charges involved). The SEC has appealed Judge Rakoff’s decision, rather than returning to the Judge with a different settlement, as they did with the Bank of America case in 2010. Judge Rakoff’s actions have instigated a great deal of public debate over the standard language used in SEC settlements, and could have an effect on the SEC’s settlements in the future.

4. Federal Agencies Target Ponzi Schemes in Greater Numbers
In 2011, federal agencies noted that they were attacking Ponzi schemes in greater numbers than ever before. As an example, the CFTC carried out a record 32 enforcement cases involving Ponzi schemes, a 45 percent increase from 2010. See article here. The FBI had over 1,000 inquiries concerning Ponzi schemes, 150% more than in 2008. The SEC notes that it has brought more than 100 enforcement actions against nearly 200 individuals and 250 entities for carrying out Ponzi schemes since the year 2010. Faced with the embarrassment of discovering the Madoff Ponzi scheme 20 years after it started, it seems the agency is striving to prevent another oversight.

Some notable Ponzi scheme allegations this year included James Davis Risher, who was accused of targeting elderly and unsophisticated investors in a $22 million Ponzi scheme and who pleaded guilty in federal court in August 2011, Allen and Wendell Jacobson, a father and son accused of perpetrating a $220 million Ponzi scheme that targeted members of the Mormon Church, and the Fair Finance Company and three executives, accused of orchestrating a $230 million offering fraud involving at least 5,200 investors, many of whom were elderly. Many Ponzi related actions resulted in parallel criminal actions as well.

3. SEC’s Whistleblower Program Launches
In May 2011, the SEC adopted the final rules that would launch the whistleblower program created under the Dodd-Frank Act. The whistleblower program was launched with a very enticing incentive – a percentage ranging from 10-30% of any recovery by the SEC of over $1 million in a successful enforcement action that was spurred by the whistleblower’s tip. In addition to offering legal protection to employees from retaliation for reported potential securities law violations, the monetary incentive is likely to encourage detailed and effective tips from individuals or employees with knowledge of potential violations. In the first seven weeks of the program alone, 337 tips were received by the SEC. The whistleblower program also allows individuals to submit tips anonymously through an attorney. For more information, see our previous blog posts on the subject, here and here.

2. Continued Aggressive Enforcement of FCPA Violations
Although 2008 marked the year of the largest settlement ever for Foreign Corrupt Practices Act (“FCPA”) violations (the Siemens case), 2011 marked a continued effort by the SEC and the US DOJ to aggressively prosecute FCPA violations. For example, the sixth largest FCPA settlement to date took place in 2011 – a massive $218.8 million settlement from the Japanese corporation JGC, for allegedly paying $180 million in bribes to Nigerian officials. Just days before the year’s end, the SEC & DOJ marked the tenth largest FCPA settlement ever when it was announced that Magyar Telekom Plc of Hungary and its majority owner Deutsche Telekom AG of Germany would pay $95 million in criminal penalties, disgorgement and prejudgment interest in connection with sham consultancy contracts with an intermediary that paid €4.875 million to Macedonian officials and falsifying books and records concerning Magyar’s activity in Montenegro.

Deloitte reported that nearly 2/3 of corporate executives, investment bankers, private equity executives and hedge fund managers whom they surveyed stated that they renegotiated or pulled out of planned business relationships, mergers or acquisitions in the last three years due to FCPA concerns. Indeed, even though only 16 corporate cases were pursued this year, compared to 20 in 2010, 18 individuals were charged with FCPA violations, second only the number of individuals charged in the record-breaking year of 2009. See article here. This significant number of individual prosecutions marked an interesting shift toward individual responsibility for FCPA violations, which are viewed as corporate violations. See article here. In fact, the largest individual FCPA forfeiture to date occurred in 2011, when Jeffrey Tesler paid nearly $149 million based on allegedly bribing Nigerian officials in exchange for certain contracts in the state. Mr. Tesler was the former middleman to KBR and its TSKJ partners Snamprogetti, Technip, and JGC. The FCPA Blog has an interesting post on Mr. Tesler’s forfeiture here. This large forfeiture certainly should serve as a warning signal for individuals heading into 2012 – the SEC and DOJ will not hesitate to pursue individuals for FCPA violations, and all signs indicate that enforcement will continue aggressively in the new year.

1. The Year of Insider Trading
The SEC and US Attorney’s Office aggressively pursued insider trading cases in 2011, more so than the year before. In 2011, the SEC and the US Attorney’s Office obtained a record prison sentence and record financial penalty for insider trading, and have showed no signs of slowing down. Judge Rakoff even remarked that decades have passed and insider trading is still rampant, noting that deterrence is an important aspect of handing out penalties and prison sentences. 2011 was monumental in the SEC’s and US Attorney’s Office’s efforts to crack down on insider trading.

The most notable case was that of Raj Rajaratnam, who was convicted of 14 counts of conspiracy and securities fraud in connection with his insider trading in several public companies. Mr. Rajaratnam was arrested along with other former and current traders at Galleon Group, one of the largest hedge fund management firms in the world at the time, which Mr. Rajaratnam founded. Mr. Rajaratnam received an 11 year prison sentence, the largest ever in an insider trading case, and a $92.8 million penalty, the largest ever assessed against an individual for insider trading. A number of his co-conspirators also received prison sentences, with one individual receiving a ten year sentence and the other 13 receiving an average 3 year sentence. The Rajaratnam case certainly underscored the US Attorney’s Office eagerness to pursue record-breaking prison sentences for insider traders, as exemplified by the 19-24 years in prison the prosecution requested in Raj Rajaratnam’s case. Rajat Gupta, who was on the boards at many large public companies, educational institutions and charitable organizations, was also charged this year, and has been accused of providing inside information to Mr. Rajaratnam for him to trade on.

In April 2011, the SEC charged a former Wilson Sonsini Goodrich & Rosati, Cravath Swaine & Moore and Skadden Arps attorney and a Wall Street trader for their involvement in a $32 million insider trading ring. The US Attorney’s office made arrests in a parallel action. The attorney allegedly accessed information on 11 mergers and acquisitions involving the law firm’s clients and then tipped a middleman. This case highlighted how federal agents were able to obtain wiretapped conversations among the attorney, the trader and the middleman, despite the group’s belief that they were acting in an abundance of caution by using disposable cell or pay phones and by using cash from small bank accounts to pay off the scheme.

More recently, James Fleishman, a former hedge fund consultant who worked at Primary Global Research, received 2 and a half years in prison for orchestrating a secret exchange of information between hedge fund traders and employees at companies. Mr. Fleishman had faced 25 years in prison, which is even greater than the sentence requested in Mr. Rajaratnam’s case. This case has had an impact on the financial services industry – expert-network consultants and companies who use such consultants may face regulatory inquiries in light of cases like Mr. Fleishman’s. As a result of the arrests associated with Primary Global and even with Raj Rajaratnam (who claimed his research came from a network of private individuals), many financial firms have stopped or reduced the use of expert-network firms, which connect large investors with outside specialists, simply to avoid the appearance of impropriety. See article here.

This small sample of the insider trading cases that took place in 2011 illustrates the SEC’s and the US Attorney’s Office’s continued effort to aggressively prosecute insider trading violations. The new year will likely continue in the same vein, although it will be hard to top the record breaking year the agencies had in 2011.

Legal Developments in Securities Law

Investors and Investment Advisers Beware: The Use of Social Media in Financial Services
Recently, the SEC charged an investment adviser for violations of the securities laws based on offerings on LinkedIn. Social media has obviously taken on a greater role in everyday life in recent years, with many businesses utilizing outlets like Facebook, Twitter, LinkedIn, YouTube and even blogs (check out our social media guide below for a breakdown of the types of social media, in case you are unfamiliar). The SEC’s enforcement proceeding and the guidelines it released simultaneously are instructive particularly for individuals in the financial services industry and for individuals interested in investing their money in something of which they learned through social media. Here are the salient points to take away from the SEC’s recent guidance.

Investment Advisers: The Securities Laws Apply to the Use of Social Media
It should be obvious that the securities laws do apply to all representations that registered investment advisers (“RIAs” or “firms”) publish to the various social media outlets. Firms should pay careful attention to the antifraud provisions, compliance provisions, and recordkeeping provisions, as specified by the SEC in its January 4, 2012 National Examination Risk Alert. In its Risk Alert, the SEC Staff addressed three areas of review for firms to consider: (A) Compliance Programs Related to the Use of Social Media, (B) Third Party Content, and (C) Recordkeeping Responsibilities.

(A) Compliance Programs Related to the Use of Social Media
Overall, the SEC highlighted that firms’ compliance policies and procedures may not be designed to address social media concerns specifically, causing some confusion about what is permitted and which policies apply to social media use. The SEC provided a number of factors to firms to help evaluate the effectiveness of their compliance programs’ effectiveness vis-à-vis social media, which includes usage guidelines, content standards, monitoring, frequency of monitoring, approval of content, firm resources, criteria for approving participation, training, certification, functionality, personal/professional sites, information security and enterprise wide sites. Particularly, firms may need to consider adopting policies to address investment advisory representatives’ (“IARs”) or solicitors’ business that is conducted on personal or third-party social media sites. As an example, an IAR may have a personal Facebook, but may use his or her network of “friends” as a business opportunity. Although the SEC notes that including business card information may be acceptable, individuals who exceed that very narrow scope may run afoul of the securities laws, and will also implicate their RIAs by doing so. Firms may also have to adopt policies or install firewalls to prevent individuals within the firm’s computer system from uploading sensitive customer information or the firm’s own proprietary information to social media sites. Firms may choose simply to block access to social media sites from within their computer network to avoid such security concerns. To the extent that firms do allow content on social media sites, it should be carefully scrutinized and submitted to such sites only after the compliance department has reviewed the content and approved it. Obviously, consulting an experienced attorney is important for firms to ensure they have built an effective compliance program, but the SEC’s guidance is an important first step for firms or even IARs or solicitors to take to evaluate their use of social media.

(B) Third Party Content
If a firm or IAR operates a Facebook page or similar social media site, third party content is often permitted and indeed encouraged. Individuals can choose to “post” comments, videos, articles, photos, etc. to the firm’s or IAR’s social media site. The SEC noted that clicking “like” on a social media site, such as Facebook, could constitute a “testimonial” under the Advisers Act, and could be the type prohibited under Rule 206(4)-1(a)(1). Per the SEC’s example, clicking “like” concerning an IAR’s biography on a social media site would be considered a prohibited testimonial. Firms or IARs could limit the risks inherent in third party content by:

  1. Not allowing for any third-party postings on their social media sites;
  2. Deleting third-party postings or “likes” if the social media site does not have the option to limit such postings;
  3. Limit third-party postings to approved users;
  4. Posting disclaimers directly on their site stating that they do not approve or endorse any third-party communications posted on their site in an attempt to avoid having a third-party posting attributed to the firm; and/or
  5. Putting in place policies and procedures to address third-party postings.

(C) Recordkeeping Responsibilities
The recordkeeping obligations under the Advisers Act do not distinguish between the various types of social media or other electronic communications (discussion boards, chat rooms, instant messages, texts, e-mails). If a firm or its IARs communicate through social media, the firm must ensure that it can maintain all required records to have them easily available for inspection, for the applicable retention period. The firm must also evaluate all of the social media communications to determine whether they are indeed required records under the Advisers Act. The firm’s compliance department should also ensure that records are being properly maintained. Consulting with an experienced attorney is important to ensure that the required records are being kept for the required amount of time.

Investors: Be Careful What You Believe Via Social Media
In light of the SEC’s recent proceeding against an Illinois-based investment adviser who was allegedly offering to sell fictitious securities on LinkedIn, the SEC likewise issued an alert to investors, entitled Investor Alert: Social Media and Investing – Avoiding Fraud. Individuals often maintain their own Facebook, LinkedIn, and Twitter accounts, and will also use resources such as blogs or YouTube videos to obtain information on potential investments. Even searching one of the popular search engines for more information on a potential investment could lead potential investors to any one of these sites, among many others, such as discussion boards or business review sites. It’s not unusual for an investor to do some investigative research on a company or investment by Googling them – but some of the search results may include fraudulent information on an otherwise legitimate website. The SEC has a number of tips to help investors navigate the stormy waters of social media.

1.“Be Wary of Unsolicited Offers to Invest”
This shouldn’t come as a surprise – people are usually wary of any kind of unsolicited offer, but sometimes these “investment opportunities” can appear particularly enticing in a difficult economic market. If someone whom you don’t know sends you an e-mail inviting you to purchase an haute couture purse for $25, your first reaction will likely be to click the delete button because it’s likely a counterfeit purse (among other reasons). An unsolicited e-mail to invest in a one-of-a-kind opportunity should likewise be treated with suspicion. This kind of message may come up via e-mail, a chat room, a Facebook message, a tweet sent to the investor, or a message directed at the investor on a discussion board. The same message holds true – be incredibly cautious about such offers to invest.

2. “Look Out for Common ‘Red Flags’”
We’ve blogged in the past about how if it sounds good to be true, it probably is. The SEC repeats this warning to potential investors, and notes that investors should beware of phrases like “INCREDIBLE GAINS,” “BREAKOUT STOCK PICK,” and “HUGE UPSIDE AND ALMOST NO RISK!” The SEC notes that investors should take a look at the returns on well known stock indexes – if the promised amount is substantially more, it could be incredibly risky or simply fraudulent. The SEC also mentions that “guaranteed” investments will carry lower returns, and every investment involves some degree of risk. “Risk free” investments are a huge red flag. Finally, the SEC notes that investors should think about each “opportunity,” and not be rushed into an investment.

3. “Look out for Affinity Fraud”
This type of investment scheme is particularly dangerous, as it has a more personal connection than random unsolicited offers. If an individual is a member of an organization or a group, especially online, he or she may be particularly susceptible to investing in an opportunity recommended by a fellow group member. Even if the individual personally knows the person suggesting the investment opportunity, he or she may be the victim of fraud and mistakenly may believe the investment is legitimate. Exercise extreme caution with any offers made through your connection to an organization, religion or group – recently, the SEC has brought enforcement proceedings against individuals who allegedly targeted fellow members of the Church of Jesus Christ of Latter Day Saints through church functions.

4. “Be Thoughtful About Privacy and Security Settings”
Keeping your personal information safe is especially important on the Internet. Do not give away any of your sensitive financial information on social media sites – even if prompted by a supposedly “official” looking account. Hackers can send e-mails or messages from accounts that appear to be from your financial institution, but which are really ploys to obtain your financial information for their own illicit motives. Overall, if you maintain a social media site, consider changing your privacy settings to “friends only” or “private,” to cut back on potential unsolicited investment “opportunities.”

5. “Ask Questions and Check Out Everything”
Many investors who are victims to investment fraud could have avoided the loss of their money by doing some simple research. Check the SEC’s website and its EDGAR system for company filings or your state’s securities regulator’s site (for New York’s Investor Protection Bureau website, click here). You can also check FINRA’s BrokerCheck for more information on registered brokers and the SEC’s Investment Adviser Public Disclosure website for RIAs. Check to see if the company you are investing with has a legitimate address – it could just be a P.O. Box or mailbox. Check the SEC’s website for disciplinary proceedings that may have involved the company or the individual(s) with whom you’ve communicated. Sometimes the Better Business Bureau may have information on complaints lodged against the company. Finally, trust your instincts, and if the research you’ve done doesn’t add up, don’t fall for the hype.

The SEC also posted information on the common types of schemes investors may face and listed a number of resources for victims of investment fraud. Of course, investors who feel they have been defrauded should consider finding an experienced attorney who will be able to assist them with their claims.

Firms and Individuals Should “Like” the SEC’s Recent Alerts
In sum, the SEC’s new guidance on the use of social media is helpful to firms and investors alike, and likely indicates that the SEC will carefully monitor all forms of social media for potential securities fraud violations. If you suspect you have encountered securities fraud through your use of social media, consult with an attorney who may assist you with filing a Whistleblower complaint with the SEC, as we specified in our blog post here. If you are an individual or firm in the financial services industry, pay heed to the warnings from the SEC and ensure that you have an effective compliance system in place, which can be set up with the assistance of a competent attorney.

Social Media Guide

Facebook: Initially started as a social networking site for a select few colleges, Facebook has expanded to over 800 million active users. Used by individuals and businesses alike, Facebook offers the opportunity to create a “Profile,” which can include information on your contact information, interests, photos, and other personal information. Users can also post “status updates” on any topic they may choose. The site also includes a “Wall,” which enables individuals to post comments, photos, videos, articles, etc. to the individual or business’s page. Facebook also includes an instant messaging system, a message system similar to e-mail and a “Like” button under posts by other users which you can click if you “Like” the post. Facebook offers users the opportunity to customize privacy settings, so that only certain parts of a user’s profile can be visible to everyone, while others can be made private, or even available only to certain users.

LinkedIn: LinkedIn is a social networking site used primarily for professional networking, and it has over 135 million registered users. The site helps individuals build a network of connections, which can then be used to find business opportunities, jobs and other people. LinkedIn also features groups, ranging from alumni associations to professional bar associations, which encourage users to post comments or questions. The user’s profile will typically include his or her work experience, similar to a resume, and can include a photograph.

Twitter: Twitter is a social networking site that is essentially microblogging, and it has over 300 million users. Users “tweet” messages of up to 140 characters, and can “tweet” at specific users by using @, or can use a hashtag # to signify a topic or phrase, which could become a “trending topic,” or one of the most popular topics at the moment. Twitter is used by a vast variety of users – the government, individuals, businesses, etc. Twitter is becoming the first source for breaking news for many individuals, with its instantaneous ability to convey information publicly. Even unregistered users can view tweets from its users, unless the user has restricted his or her account.

YouTube: YouTube is a video-sharing website, which enables users to upload, share and comment on videos. Although often thought of as a means to listen to new singers or specific songs, to find clips from television shows or to view funny videos, YouTube is being used more and more by companies to post advertisements or information about themselves.

Blogs: Blogs are similar to journals and often concern a particular subject, and there are over 156 million public blogs currently in existence. Many businesses have started using blogs to provide commentary on subjects pertinent to the fields in which they operate. A blog can be an interesting source of information for different viewpoints or insight into certain topics. Some blogs are more personal, akin to a diary. Some blogs have even developed into important news sources, such as those that have exposed political scandals. Blogs will often allow comments and can spur interesting debates on various subjects.

Bulletin Boards: Much like a community bulletin board, online bulletin boards encourage users to post public messages about any topic imaginable. Sometimes called internet forums, each new discussion starts a thread, and users can comment on the thread until the forum moderator decides to close commenting (if he or she does so at all). Users can post with usernames that will keep their true identities anonymous. Threads may start with questions like “How do I fix a flat tire?” or “What do you think about investing in gold?” Although there are moderators for such forums, that does not guarantee the truth or accuracy of the statements on these forums.

Google+: Google’s answer to Facebook, Google+ is a social networking site that has around 62 million users. Google+ has features like Facebook, such as a profile, a messenger and the ability to post updates, but also includes things like a user’s “Circles” or a collection of contacts, “Hangouts” or places to facilitate group video chat, or sharing links that the user found interesting or useful. Although Google+ has not caught on to the same degree as Facebook, it’s expected that its number of users will grow greatly in 2012.