9th Circuit Upholds Coordinated SEC/DOJ Investigations

U.S. v. Stringer

Although I rarely discuss non-SEC opinions the Ninth Circuit has just issued an important decision for all practitioners that deal with joint SEC/Department of Justice investigations.  Contrary to the claims of some, this is a major win for the SEC.  It ends the time wasting claims by some defense counsel that have tied up SEC resources in subpoena enforcement cases where persons receiving subpoenas argued that coordinated investigations are per se improper. Further, the decision will not restrict SEC investigations by hindering witness cooperation as all experienced defense counsel already know that the SEC and DOJ always share information and counsel never advise clients who may have potential criminal liability to cooperate with the SEC without an immunity grant.  Experienced defense counsel know that the only way to deal with an SEC investigation is to assume that the DOJ may be involved and to (in the words of Jack Nicholson)  "act accordingly," that is, either fully cooperate or take the Fifth.  Last, one commentator has argued that this, like the Martha Stewart case, will discourage cooperation with the SEC.  Again, I beg to differ.  The lesson from the Martha Stewart case is simple, if you are going to testify before the SEC, tell the truth.

In recent years various defense counsel have attempted to argue that it is inherently improper for the SEC and DOJ to conduct joint investigations and to share information they develop. Some have attempted to argue that any such investigations be completely independent and that any sharing of information or coordination between the SEC and DOJ is verboten.  This case should put and end to these defense claims.

Here, the court of appeals overturned a district court decision dismissing an indictment after finding that the SEC's practice of not disclosing details of its contacts with the DOJ was improper and tainted a subsequent criminal prosecution.  

Specifically, the circuit ruled:

"We vacate the dismissal of the indictments because in a standard form it sent to the defendants, the government fully disclosed the possibility that information received in the course of the civil investigation could be used for criminal proceedings. There was no deceit; rather, at most, there was a government decision not to conduct the criminal investigation openly, a decision we hold the government was free to make. There is nothing improper about the government undertaking simultaneous criminal and civil investigations, and nothing in the government’s actual conduct of those investigations amounted to deceit or an affirmative misrepresentation justifying the rare sanction of dismissal of criminal charges or suppression of evidence received in the course of the investigations."

This was more than merely parallel SEC/DOJ investigations.  As the court explained:

"The SEC facilitated the criminal investigation in a number of ways. The SEC offered to conduct the interviews of defendants so as to create “the best record possible” in support of “false statement cases” against them, and the AUSA instructed the SEC Staff Attorney on how best to do that. The AUSA asked the relevant SEC office, located in Los Angeles, to take the depositions in Oregon so that the Portland Office of the USAO would have venue over any false statements case that might arise from the depositions, and the SEC did so. Both the SEC and USAO wanted the existence of the criminal investigation kept confidential. The SEC Staff Attorney, at one of the Portland depositions, made a note that she wanted to “make sure [the] court reporters won’t tell [[defense counsel]]” that there was an AUSA assigned to the case."

The court ruled that the SEC had no affirmative duty to disclose its cooperation with the DOJ and that it was sufficient for Fifth Amendment purposes for it to disclose the possibility that it might share information obtained in its investigation with the criminal prosecutors.

Protective Order Granted For Financial Information In Connection With Appeal

Gregory O. Trautman, Exchange Act Release 57545

As is its practice, the Commission granted a protective order sealing certain personal and confidential financial information Trautman filed in connection with his pending appeal of an ALJ's initial decision that can be viewed here  (also see the ALJ's  denial of a motion to correct here).  Respondents typically file such information in an effort to establish an "inability to pay" defense to disgorgement or penalties.

NASD Sanction Against Chief Compliance Officer Upheld

Robert E. Strong, Exchange Act Release 57426

Time from appeal to decision - 11 months, 12 days.

Time from final brief to decision - 7 months, 3 days.

Pages - 33

Footnotes - 51

Summary

Strong was formerly the Chief Compliance Officer of a small firm with about 40 registered representatives.  The NASD found that he failed to: supervise the personal trading of an analyst at the firm; enforce NASD disclosure requirements for research reports; and failed to file reports with the NASD.  He was fined $10,000 and charged with costs of $3,723.  

NASD Rule 2711 imposes restrictions on personal trading by research analysts and requires that research reports contain various disclosures.  Strong was specifically hired by the firm to be responsible for compliance with the rule.   Among other things, the rule prohibits analysts from trading in a security they follow for 30 days before and five days after the publication of a report.  Strong was required to pre-approve any analyst trades and to retain evidence of the review.  He admitted that he did not do so.   In addition he did not request that the trading desk monitor activity in analyst's accounts.  In addition, there was evidence that Strong had disciplinary authority, but it was not clear that he had the ability to fire anyone.

The analyst in question here prepared ten research reports that were sent to four to five clients.  The analyst made 112 trades in stocks he followed during a 13 month period, including 41 buys of stocks that he had made buy recommendations.  Four of those buys were within 30 days of a research report on the stock.  He earned $116,000 in profits.

Strong claimed he was not responsible for supervising the trader because he did not have the authority to cancel improper trades and he was not the line supervisor of the analyst.  Here, Strong had clear supervisory responsibility over the analyst.  He in fact did have authority to cancel trades.  Further, after consultation with the president of the firm, he had authority to discipline persons for violations of compliance procedures.  The fact that the president of the firm shared supervisory duties with Strong does not exonerate him according the the Commission.  See, Steven P. Sanders, 53 SEC 889, 904 (1998) ("[E]ven where supervisory responsibility is shared between firm executives, each can be held liable for supervisory failures.").  

Strong also ignored at least one red flag of irregularity.  After the analyst liquidated his entire position in a stock he was publicly recommending, Strong did not heighten his supervision of the analyst's trading activities.  Further, for many months, Strong did not follow the requirement that the analyst's trades be pre-approved.

Rule 2711 requires research reports to disclose whether or not: the analyst owns a financial interest in the stock that is subject to the recommendation; and whether the firm makes a market in the stock.  Eight of the research reports failed to include these or three other mandatory disclosures required by the rule.  Strong claimed he was not responsible for these violations because he relied on the firm's president to monitor the reports for compliance with the rule.  The Commission rejected this argument, noting that the firm's procedures required Strong to review all research reports for the purpose of ensuring compliance with Rule 2711.

Strong also failed to file a required attestation with the NASD that the firm had in place written procedures to ensure compliance with Rule 2711.

Exchange Act Section 19(e) requires that the SEC sustain the NASD sanctions unless it finds the sanctions to be excessive, oppressive, or impose an unnecessary burden on competition.  

The Commission upheld the sanctions, noting that NASD sanction guidelines call for a fine of between $5,000 and $50,000 and a suspension.  

Comment

This case is of some note because it reiterates the obligation of supervisors even when that supervisor shares responsibility with others.  

The Commission found supervisory liability where the supervisor had the ability to, in consultation with others, impose disciplinary sanctions and where it was not explicit that the supervisor had the ability to fire.

However, the Commission continues to move at a glacial pace.  One has to wonder why it permitted four months for briefing and took seven months to issue a decision.  This was a routine matter that involved no difficult factual or legal issues. 

 

Hearing Ordered On Reg A Exemption

Euro Capital Inc., Investment Advisers Act Release 33-8898

The Commission ordered a hearing on whether to suspend the Regulation A exemption sought by Euro Capital Inc.  The ALJ was ordered to render an opinion within 120 days.

Bar For Enjoined IA - No Investor Losses

Jeffrey L. Gibson, Exchange Act Release 57266

Time between appeal and decision - 1 year, 3 months, 22 days.

Time between last brief and decision - 1 year 17 days.

Time since oral argument - 5 days.

Pages - 11

Footnotes - 33

Summary

Gibson was barred from investment adviser or broker-dealer association by the ALJ based on a previous injunction for violations of the anti-fraud provisions of the securities laws.  He sold 43 limited partnership interests to 38 investors for about $875,000 in a business that intended to buy and operate coin operated car washes.

Instead of investing the funds as specified, Gibson misappropriated about $450,000 of the money he had raised from investors by investing the funds in other commercial real estate. Gibson had also told investors that investor funds would be invested in money market funds until car washes could be acquired.  Gibson also sent post-investment lulling letters to investors the purported to describe rates of returns from various properties, without telling investors that the funds had not been used as claimed in the offering materials.

He consented to a district court injunction and he was ordered to pay a penalty of $25,000 and to disgorge $427,000 to investors.  He liquidated the commercial real estate to pay the penalty and disgorgement amounts.

At the trial before the ALJ the Division of Enforcement moved for summary disposition.  Thirty-one investors filed substantially identical declarations claiming to "ratify" Gibson's actions and stating they wished him to remain their investment adviser.  The ALJ granted the Division's motion.

Using the standard factors set out in Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979) in determining what sanctions are in the public interest, the Commission upheld the ALJ's bar.  Here, the Commission found that Gibson's misappropriation occurred over a three year period, involved several types of misconduct, and involved a large number of his clients.  It also concluded that Gibson's conduct exhibited a high degree of scienter.

Comment

Again the lesson is simple.  Enjoined investment advisers who have court orders prohibiting anti-fraud violations will be barred even when there are no investor losses.

Further, the Commission will ignore the wishes of investors.  Indeed, it found that Gibson's ability to retain the confidence of his investors was testament to his persuasiveness and hence his potential ability to engage in similar misconduct in the future.

One must wonder why the Commission exercised its discretion to hear oral argument in this matter as no novel or significant issues are presented for decision.  Indeed, the Commission rejected Gibson's objection to the ALJ's granting of summary disposition finding summary disposition to be appropriate because "there is no genuine issue with regard to any material fact. . . ."  The lack of novel factual or legal issues is further underscored by the fact that the opinion was rendered only five days after the argument.  Under these circumstances, the Commission's decision to wait one year and 12 days to hear oral argument is puzzling.  If there were no issues of material fact confronting the trial judge, and the opinion itself relies on extensive Commission precedent, it is puzzling that: 1) the Commission even decided to hear oral argument; and 2) it took more than a year to schedule the oral argument.

Adelphia Audit Partner Sanctioned - No Reliance On Prior Audits

Gregory M. Dearlove, AAER 2779

Time since appeal filed - 2 years, 4 months, 1 day.

Time since final brief filed - 2 years, 27 days.

Time since oral argument - 1 year, five months, 7 days.

Pages - 60

Footnotes - 168

Summary

This is a disciplinary proceeding against a CPA and arises from the Adelphia fraud. Respondent was formerly a partner at Deloitte & Touche and was the engagement partner for the audit of Adelphia for the 2000 audit of that firm. He was denied the privilege of appearing or practicing before the Commission with a right to reapply after four years.  He was also ordered to cease and desist violations of Exchange Act Section 13(a).  The ALJ had barred him from appearing before the SEC.

Adelphi filed for bankruptcy in June 2002 after disclosing related party transactions with the Rigas family that controlled the company.  As part of a settlement with the Department of Justice, Adelphia agreed to pay $715 million to a victims' restitution fund and the DOJ declined to file criminal charges.  In 2005 the Rigas settled civil charges brought by the Commission and consented to injunctive relief.  The Commission also brought an administrative action against Deloitte which the firm settled, among other things it agreed to a $25 million penalty and consented to findings it had "engaged in repeated instances of unreasonable conduct" concerning the 2000 audit of Adelphia.

This opinion contains a comprehensive discussion of the Generally Accepted Auditing Standards (GAAS) that apply to audits of public companies.  Among other things, "[u]nless and until an auditor obtains an understanding of the business purpose of material related party transactions, the audit is not complete."

Respondent argued that he should have been able to rely on the fact that the related party transactions had been subject to prior year audits.  The Commission rejected Dearlove's argument, stating "[W]e reject any suggestion that the conduct of prior auditors should be a substitute for the standards established by GAAS."  Further, it noted that rotation of auditors has long been required by the AICPA and federal law as a means of insuring impartiality. The Commission also rejected this defense on factual grounds, finding that the 2000 audit did not document how the prior audits were performed or what evidential matter supported those conclusions.  

Much of the opinion discusses highly technical accounting issues.  Those are summarized very briefly below.

The Commission noted that it was improper for Adelphia to net its related party receivables and payables.  Also, the company reflected a dramatic drop in the net figure, which the Commission found should have alerted the auditors to more carefully scrutinize this matter. Dearlove could not explain how the audit had tested this practice by the company.  The work papers do not reflect that the auditors gave any consideration to the propriety of this netting by the company.  The Commission found that Dearlove accepted the practice "primarily, if not solely" because the prior auditors had as well.

The ALJ rejected the Division of Enforcement's claim that Adelphia's treatment of various debt as a contingent, rather than a primary liability was wrong.  The Division did not appeal this finding.  Nevertheless, the Commission found that Dearlove's auditing of this was not in compliance with GAAS.  This is an important finding, accountants will be held liable for a GAAS violation even if the underlying accounting was appropriate.  Thus, getting to the right result is not a defense in a Rule 102(e) proceeding.  In support of this conclusion, the Commission noted that disclosures relating to the debt were not adequate.

Adelphia transferred debt from its subsidiaries to various Rigas controlled entities after the close of quarters, but nevertheless retroactively reflected the lesser debt amounts on the company's books. The Commission found this debt reclassification a violation of GAAP, even though there was no expert testimony that supported this conclusion.  The absence of expert opinion does not prevent the Commission from making findings as to the "principles of accounting."

The Rigas acquired Adelphia stock with funds borrowed jointly by themselves and Adelphia.  This debt was not recorded on Adelphia's books.  The Commission also found the auditors violated professional standards in their audit of these transactions.

The opinion contains a comprehensive discussion of the factors the Commission will consider when disciplining auditors.  It noted that auditors play a crucial rule in the system of public reporting as "[i]nvestors have come to rely on the accuracy of the financial statements of public companies when making investment decisions.  Because the Commission has limited resources, it cannot closely scrutinize every financial statement.  Consequently, the Commission must rely on the competence and independence of the auditors who certify, and the accountants who prepare, financial statements.  In short, both the Commission and the investing public rely heavily on accountants to assure corporate compliance with federal securities law and disclosure of accurate and reliable financial information."

It also noted that a negligent audit can inflict as much harm on investors as one that is conducted with an improper motive.  

The Commission found that it was appropriate to impose a cease and desist order against Dearlove for causing Adelphia's Exchange Act reporting violations.  In doing so it reiterated a three part test for "causing" liability namely: 1) a primary violation; 2) respondent contributed to the violation; and 3) respondent knew or should have known his conduct would contribute to the violations.  It further noted that negligence was sufficient to satisfy the knowledge requirement of the test.

The Commission rejected Dearlove's claim that the Commission's rule that set a deadline for trial judge to issue an opinion violates due process because here, a motion for a sixty day postponement of the trial was denied by the judge.   In rejecting this argument the Commission cited to the test set forth in Unger v. Sarafite, 376 U.S. 575 (1964) which noted that there is no mechanical test for deciding when denial of a continuance is so arbitrary as to violate due process.  The Commission noted that it has long articulated the test in terms of whether the denial "constituted 'an unreasoning and arbitrary insistence upon expeditiousness in the face of a justifiable request for delay.'"  In the past the Commission has rarely found a denial of due process when there were extraordinary circumstances for a postponement of trial, such as the respondent being left without counsel shortly before the hearing.  Here the judge's schedule allowed for 121 days between service of the order and completion of the hearing.  Further,  counsel was familiar with the matter as he had been involved in the matter for the two prior years when respondent's investigative testimony was taken.

Comment

The Commission's finding that Dearlove violated GAAS even though the accounting treatment of a debt item was appropriate is highly significant for auditors of public companies.  They can thus be held responsible for bad auditing practices even if the underlying accounting was valid.

Also noteworthy is the Commission's conclusion that it may make findings that accounting principles were not properly applied even absent expert testimony to support such a finding.  The Commission will make its own judgments about what constitutes proper accounting treatment of a transaction.

The Commission noted that under some circumstances "unreasonable conduct is not necessarily a less egregious disciplinary matter than either intentional or reckless conduct, or highly unreasonable conduct in circumstances warranting heightened scrutiny."

The Commission allowed respondent to reapply for reinstatement after four years. It stated, with little explanation, that it believed this sanction would encourage rigorous compliance with auditing standards, without being punitive.  This reversion to ipse dixit reasoning may cause the Commission issues before the court of appeals should an appeal be taken.

The Commission's finding that an auditor who signs an audit report after conducting an audit that does not comply with GAAS contributes to a violation of the reporting provisions is significant.

The Commission's ruling that there was no due process violation because the trial judge denied Dearlove's motion for a 60 day continuance after scheduling 121 days between the start of the proceedings and conclusion of the trial is one that practitioners should note.  This is another case where the Commission is clearly signaling that it will not interfere with scheduling or trial management decisions by its ALJs.  It pointed out that Commission rules specify such deadlines are not rigid and that the trial judge can petition the Commission to extend the deadline for rendering an initial decision.  Someone prone to sarcasm might note that the Commission took significantly longer than 121 days after oral argument to render its opinion, let alone the 300 days it allocated for the ALJ to conclude the trial and render an opinion.

Corporate Officers, Registered Reps And Supervisor Sanctioned

John A. Carley, Eugene C. Geiger, Thomas A. Kaufmann, Edward H. Price, Christopher H. Zacharias, Exchange Act Rel. 8888

Time between appeal and opinion - 2 years, 5 months, 26 days.

Time between final brief and opinion - 2 years, 1 month, 3 days.

Time between oral argument and opinion - 11 months, 24 days.

Pages - 51.

I supervised this matter when I was still at the Commission so I will not provide editorial comment or extensive discussion.  However, please note that the dates listed above are not typographical errors.  A brief summary of the case follows.

This matter involved a complex unregistered public distribution of stock by officers of a public company assisted by two registered representatives at a broker-dealer.  It involves very complex issues under the registration provisions of Section 5 of the Securities Act and also the supervisory duties of a broker-dealer.  

Anyone interested in a comprehensive discussion of Securities Act registration would be advised to consider the Commission's discussion of these sometimes difficult issues.  The opinion reiterates that broker-dealers must be vigilant to red flags that may alert them that they are participating in an unregistered distribution of stock by corporate insiders.

Cease and desist orders were entered against all respondents charged with violations (failure to supervise is not a violation).  One registered representative was barred, another was barred with a right to reapply after five years and the supervisor was barred from acting in a supervisory capacity.

The two corporate officers were ordered to disgorge a total of $4 million between them and ordered to pay prejudgment interest totaling $2 million.  Each of the registered representatives was ordered to disgorge $873,000 and pay prejudgment interest of $454,000. Each representative was also ordered to pay a civil penalty of $110,000 and the supervisor was ordered to pay a $55,000 penalty.  

ALJ's Motion To Extend Time For Decision Denied As Moot

Trautman Wasserman & Co., et. al., Exchange Act Rel. 57243

Now for some real trivia folks.  The ALJ moved for an extension of time in which to file her initial decision, but rendered that motion moot by filing her decision before the deadline.  The Commission therefore denied the pending motion by the judge.

Comment

If the Commission can publish this why can't it publish the briefs of the parties in its cases?

Investment Adviser Barred For Inflating Performance Data And Assets Under Management

Warwick Capital Management, Inc., Advisers Act Rel. 2694

Time between appeal and decision - 10 months, 21 days.

Time between last brief and decision - 7 months, 26 days.

Pages - 21.

Summary

The control person of an investment adviser who claimed inflated assets under management and performance results will be barred.  A bar and cease and desist orders are appropriate despite the fact that there was no misappropriation of investor funds.

Warwick, an investment adviser and its president Lawrence appeal an initial decision by an ALJ.  The law judge found respondents: 1) violated Section 203A of the Advisers Act by maintaining its registration with the Commission despite having less than $25 million under management; 2) respondents violated Advisers Act Sections 206(1) and (2) and Warwick violated and Lawrence aided and abetted violations of IA Section 206(4) by falsely representing total assets under management and publishing false performance data.  The ALJ barred Lawrence and entered cease and desist orders against both respondents.

After 1997 when advisers needed $25 million under management to qualify for Commission registration, Warwick reported between $26 and $37 million under management.  This was a sharp increase over the $5 million it had reported 8 months earlier.  Warwick's registration was cancelled by the Commission in January 2002 and it never filed to withdraw its registration.  Warwick continued to hold itself out as registered with the Commission after that date.  Further, Warwick continued to publicly claim it had assets under management of between $26 and $94 million through early 2004.

Lawrence admitted in sworn testimony to the Commission staff that between 1998 and 2003 he had only between $2 million and $10.5 million under management.  Although Lawrence claimed to have managed substantial other assets, the ALJ found those claims to be not credible and unsupported by credible evidence.

Warwick also published inflated performance return data, claiming annual returns as high as 77 percent.  Lawrence admitted in testimony the actual return was about 25 percent.  He claims to have sent a correcting letter to a data service changing the returns he first claimed, but the service never received his purported letter.

At the hearing, Lawrence claimed various records were destroyed in a fire.  Unfortunately for him, he had previously testified the records were destroyed in a flood.  Apparently he never got around to claiming the destruction was by a horde of locusts.

In upholding the finding that Lawrence aided and abetted violations by Warwick, the Commission noted that recklessness satisfies the knowledge requirement for aiding and abetting, citing the formulation in Sundstrand Corp v. Sun Chem. Corp., 553 F.2d 1033, 1044-1045 (7th Cir. 1977).  Lawrence's aiding and abetting was established because he signed documents with the false performance data.  Because he was solely responsible for managing Warwick, the Commission found Lawrence must have known that the claimed amount of assets under management was inflated.

Inflated performance data and size of assets under management are material because they gave an erroneous impression of the firms size and abilities.  Investors routinely consider an adviser's past performance and attractiveness to other investors when making investment decisions.  Respondents are liable for misrepresentations made to a data service because they knew that those statements would be repeated or otherwise conveyed to investors.

Conduct occurring more than five years before the proceedings were instituted maybe the basis for imposing sanctions or civil penalties (see 28 U.S.C. 2462).  However, such evidence may be considered to establish motive, intent, or knowledge in committing violations within the limitations period.  And, no statute of limitations applies to consideration of the cease and desist remedy. 

Comment

The Commission will require advisers to prove with credible evidence claims that they meet the asset test in order to maintain registration.  

Over the years, some of the Commission ALJ's have been unwilling to admit prior sworn testimony by respondents as substantive evidence, despite authority for doing so.  Here, the Commission considered prior inconsistent sworn testimony by a respondent.  Note, Commission case law also admits as substantive evidence for all purposes prior sworn testimony of non-respondents, a practice that is contrary to the federal rules of evidence.  See, Allesandrini & Co., 45 S.E.C. 399 (1977).

The Commission rejected the Division of Enforcement's request for second tier penalties, with very limited explanation.  It concluded that the bar and cease and desist orders were sufficient remedies primarily because Warwick only had two clients at the time of the hearing and because Warwick would have to cease operations due to the bar imposed on Lawrence.

Appeal From NASD Action Dismissed For Lack Of Jurisdiction

Wedbush Morgan Securities, Inc., Exchange Act Rel. 57138

Pages - 5

Summary

When does the Commission have jurisdiction over a NASD action?  Only when the order is final and imposes a disciplinary sanction, denies membership, prohibits or limits access to NASD services, or bars a person from association.  

Wedbush appealed a NASD hearing officer decision finding the firm had failed to make full payment of an arbitration award that totaled $3.8 million.  The firm's registration was ordered suspended unless it provided documentary evidence it had paid the award by a specified date.  Wedbush paid the award by that date and the suspension therefore did not take effect.  It nevertheless appealed to the Commission, claiming the decision was wrong and that it was denied due process by the hearing officer.

The Commission dismissed the appeal. The NASD argued that the Commission has no jurisdiction over the appeal as it was not the type of proceeding covered by Section 19 of the Exchange Act which gives the Commission jurisdiction over NASD sanctions of various types.  Wedbush was not subject to a final NASD disciplinary decision appealable to the Commission because the suspension never went into effect.  Nor did the NASD's action meet any of the other jurisdictional actions covered by Section 19.

Comments

Section 19 of the Exchange Act governs Commission appellate jurisdiction over NASD appeals.  The Commission will interpret the section strictly.