Archive for the ‘Securities’ Category

Last year the SEC announced it was adopting new procedures to encourage greater cooperation in its enforcement investigations, including the use of cooperation agreements, non-prosecution agreements and deferred prosecution agreements. Non-prosecution agreements and deferred prosecution agreements are typically used in criminal proceedings to encourage cooperation by important witnesses and provide fair and specific treatment of cooperating witnesses.  To understand their use by the SEC it is helpful to understand how these tools developed under federal practice.

The Department of Justice has used these agreements for years in corporate fraud cases.  The infamous “Thompson Memorandum”, written by Larry Thompson of the DOJ in 2003 to help federal prosecutors decide whether to charge a company with criminal offenses, required that a company must

  1. turn over materials from internal investigations,
  2. waive attorney-client privilege, and
  3. not provide targeted executives with company-paid lawyers,

before the company could claim credit for cooperating with the DOJ.   In other words, a company might provide extensive cooperation to the DOJ, but would not get any credit for that cooperation unless it expressly gave up its rights and breached its indemnification contracts.  Nearly every public company has indemnification agreements with its directors and officers, and indemnification is provided in the corporation statutes of Delaware, Colorado, and most other states. While eviscerating the constitutional rights to counsel and against self-incrimination, and the statutory right and contractual obligation to indemnification, the Thompson Memo also provided for the use of non-prosecution agreements for companies that waived their constitutional rights.

The Thompson Memorandum was replaced in December 2006 by the more reasonable “McNulty Memorandum”, which provided some relief from the most offensive portions of the Thompson Memorandum by requiring prosecutors to go through certain procedural requirements and obtain approval from senior supervisors before demanding a waiver of the attorney-client privilege.

The McNulty Memorandum was revised in 2008 (the “Filip Memo”) to prohibit the Department of Justice from coercing companies to breach their indemnification agreements with their directors and officers, to allow credit for cooperation to companies that do not waive the attorney-client privilege or do not disclose attorney-client work product, and to prohibit prosecutors from demanding attorney-client communications or attorney work product.

In contrast to the Department of Justice, the SEC does not have criminal enforcement powers, only civil enforcement powers, and must refer criminal cases to the Department of Justice.  However, over the years the SEC has sought greater cooperation from companies and people under SEC civil investigation.  For example, the SEC’s equivalent of the Thompson/McNulty/Filip Memorandums is the 2001 “Seaboard Report” describing the criteria it will consider in determining whether, or how much, credit it will give to companies who self-police, self-report, take corrective action or cooperate with the SEC.  Never mind that the “Seaboard Report” is neither about “Seaboard” nor a “report”, it stated that cooperation can result in reduced charges, lighter sanctions or mitigating language in settlements.

Despite the SEC’s more reasonable approach to the rights of companies under investigation, the Seaboard Report, and the SEC’s approach to giving credit for cooperation, were vague, and often applied after-the-fact.  In many cases, a company never really knows where it stands with the SEC, and whether it is actually receiving credit for cooperation, until after the investigation is complete.  While the Justice Department’s rules were originally offensive, at least a defendant signing a non-prosecution or deferral agreement knows exactly what to do, and exactly what treatment it will receive in return for cooperation.

To encourage the type of cooperation the SEC wants, it needs to provide the same type of certainty and fairness to potential witnesses as the DOJ, and so last year the SEC adopted new procedures for rewarding cooperation.

The SEC entered its first non-prosecution agreement in December 2010 with Carter’s Inc. In the Carter’s case the EVP of Sales, Joe Elles, allegedly gave substantial discounts to the company’s largest customer and hid them from the company.  Because the company didn’t know, it did not recognize the discounts until later reporting periods, which caused the company’s results for the quarters in which the discounts were given to be artificially inflated.  The SEC brought an action against Elles, but entered into a non-prosecution agreement with Carter’s. The SEC identified the following factors as relevant to its decision not to bring an action against Carter’s: (1) the “relatively isolated nature” of the unlawful conduct; (2) the company’s “prompt and complete” self-reporting of the misconduct to the SEC; and (3) the company’s “exemplary and extensive” cooperation in the inquiry, including a “thorough and comprehensive” internal investigation.  The SEC did not require Carter’s to waive its attorney-client privilege.

The SEC recently announced its first use of a deferred prosecution agreement, with Tenaris S.A., a manufacturer of steel pipe products from Luxemburg, listed on the New York Stock Exchange.  A world-wide internal investigation conducted by Tenaris’ outside counsel revealed Foreign Corrupt Practices Act violations in Uzbekistan, where Tenaris allegedly bribed Uzbek officials and made $5 million in profits from pipeline contracts.  The company self-reported to the SEC and the Department of Justice, cooperated with the government, and made extensive efforts at correcting the violations.

The SEC said that Tenaris was an appropriate candidate for the first deferred prosecution agreement because of its “immediate self-reporting, thorough internal investigation, full cooperation with SEC staff, enhanced anti-corruption procedures, and enhanced training.”

Under the deferred prosecution agreement, the SEC will not bring civil charges against Tenaris unless the SEC determines that the company has not complied with its obligations under the agreement.  Although Tenaris shared the results of its internal investigation with the government, the agreement does not require it to waive the attorney-client privilege.  Tenaris agreed to pay $5.4 million in disgorgement and interest.

By eliminating the Hobson’s choice of either cooperating and not knowing what will happen, or not cooperating and not knowing what will happen, the certainty provided by deferment and non-prosecution agreements will allow lawyers to better advise their clients on the consequences of self-reporting and corrective actions, and should make it easier for the SEC to secure cooperation from companies and individuals on a fair and reasonable basis.


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This is the second in a series analyzing important changes to capital markets and securities laws by the Dodd-Frank Wall Street Reform and Consumer Protection Act. On July 21, 2010 President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act.  While the Act is 2,319 pages long, it has very little immediate effect on the financial markets. Rather, the Dodd-Frank Act empowers a variety of financial regulators and government agencies to conduct studies, take testimony, publish reports and promulgate rules and regulations to enforce the various provisions of the Act.  Not unlike Twilight (New Moon), nothing much happens in the Dodd-Frank Act, but it lets you know there’s more to come.

The Dodd-Frank Act was primarily crafted to reduce the exposure of the U.S. banking system to a repeat of the 2008 melt-down, and end the potential for “too big to fail” government bail outs.  However, the Act goes well beyond the initial intent, addressing broad changes in securities laws, capital markets, banking and consumer finance.

47 Studies (or is it 67 Studies?)

Depending on whom you ask, and how you count parts and sub-parts, the exact number of studies commissioned by the Dodd-Frank Act varies.  The best estimate may be “scads”.  Studies will be conducted and reports published by the Financial Stability Oversight Council, the FDIC, the GAO, the FTC, the Federal Reserve, Treasury, the new Bureau of Consumer Financial Protection, and the SEC, among others.  In particular, the SEC will have one of the biggest roles in implementing Dodd-Frank.   The SEC has begun ramping-up to implement its role.  Compliance Week reports that the SEC will hire roughly 800 new employees, create five new offices, and revamp its internal reporting and technology processes in implementation of its broader reporting and enforcement role.

The following studies may be of interest to our clients:

  • Accredited Investors. The GAO will study and report on 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.  As I reported recently, the Dodd-Frank Act already increased the asset value required for individual investors to be “accredited” by excluding the value of the investor’s primary residence.  This report is due in 3 years.
  • Short Selling and Swaps. The SEC must report on several studies on different aspects of short selling and swap transactions.  Particularly, reporting and regulation of certain aspects of short selling are likely to be forthcoming.  While selling stock you don’t own, gambling that the price will go down, can be an effective hedge (insurance) strategy for persons with substantial and complex stock positions, short selling for speculation often vexes public companies.  Management of public companies who watch their stock go down for no apparent reason in the face of growing short positions often believe that speculators are conducting a “short and distort” campaign – taking a short position, then spreading negative rumors or false information about the company to insure a profit from the short position, or that the existence of the short position itself causes other investors to sell their stock, driving the price down and hurting the company.
  • Information on Broker-Dealers, Investment Advisers and Registered Reps. The SEC must study and recommend ways to improve investor access to registration information (including disciplinary actions, regulatory, judicial, and arbitration proceedings, and other information) about registered and previously registered investment advisers, associated persons of investment advisers, brokers and dealers and their associated persons.  This report is due by January 21, 2011.
  • Aiding and Abetting Violations of Securities Laws. The GAO must study and report on the impact of authorizing a private right of action against any person who aids or abets another person in violation of the securities laws. This is of particular interest to securities lawyers, accounting firms, and their insurers.  At common law, aiding and abetting occurs through “knowing participation” in the illegal conduct. Although knowing participation is required, wrongful intent by the defendant is not necessary.  Nor is it necessary that the plaintiff establish that an agreement existed between the defendant and the guilty party.  There is a fine evidentiary line between participating in someone else’s conduct, and knowing the conduct was illegal. Thus, when a fraudster commits securities fraud and heads for the border with the money, the aggrieved investors look for people to sue – the lawyers who prepared the offering documents, the accountants who prepared the financial statements, the financial printer, the broker dealer who sold the securities, the investment banker who advised on the deal.

Under current law the SEC may bring action against aiders and abettors, but individuals may not. In addition, the Dodd-Frank Act provides for the SEC to impose aiding and abetting liability on persons who “recklessly” provide substantial assistance to someone who violates the Exchange Act.  Previously, the SEC was required to show that such assistance was provided “knowingly.”  Private plaintiffs have been unable to bring such claims since the Supreme Court’s Central Bank of Denver decision in 1994, and the 2008 decision in Stoneridge Investment Partners blocked plaintiffs from bringing similar “scheme” liability claims.

The Dodd-Frank Act also extends aiding and abetting liability for the first time to the Securities Act, the Investment Company Act and the Investment Advisers Act. The Act also clarifies that the SEC may pursue enforcement actions against so-called “control” persons – those found to “directly or indirectly control” a violator – unless they acted in “good faith” and did not “directly or indirectly induce” the violative conduct.  This report is due in 1 year.

  • Lessen Impact of Sarbanes-Oxley on Medium-Sized Companies. The SEC will study how the SEC could reduce the burden of complying with Section 404(b) of the Sarbanes-Oxley Act for companies whose market capitalization is between $75,000,000 and $250,000,000 while maintaining investor protections for such companies, including whether any such methods of reducing the compliance burden or a complete exemption for such companies from compliance with such section would encourage companies to list on exchanges in the United States in their initial public offerings.  See Sarbanes-Oxley discussion below. This study is due in 9 months.

  • Core and Brokered Deposits.  The FDIC will conduct a one year study to evaluate:

– the definition of core deposits for the purpose of calculating the insurance premiums of banks;

– the potential impact on the Deposit Insurance Fund of revising the definitions of brokered deposits and core deposits to better distinguish between them;

– an assessment of the differences between core deposits and brokered deposits and their role in the economy and banking sector of the United States;

– the potential stimulative effect on local economies of redefining core deposits; and

– the competitive parity between large institutions and community banks that could result from redefining core deposits.

Current FDIC policy strongly discourages acceptance of brokered deposits by charging an FDIC insurance premium if brokered deposits exceed a specified percentage, and by very broadly interpreting the definition of brokered deposit.

What the Dodd-Frank Act Does Today

  • Makes it Harder to Qualify as an Accredited Investor.  As detailed in my earlier article, effective immediately, the definition of an individual accredited investor under the SEC’s Regulation D for private placements now excludes the value of the investor’s primary residence. This reduces the number of people eligible to participate in many private placements, which are often offered only to accredited investors.

  • Sarbanes-Oxley Relief. After six compliance extensions by the SEC, including a couple of “final extensions”, the matter is taken out of the SEC’s hands.  The Dodd-Frank Act provides immediate relief from the onerous Sarbanes-Oxley internal control audit provisions for approximately 5,000 smaller public companies.  Smaller public companies, (non-accelerated filers – companies with a market cap less than $75 million) are now exempt from Sarbanes-Oxley 404(b) compliance. Sarbanes-Oxley 404(a) requires a management report on internal controls, which smaller public companies must still provide – 404(b) requires external audit of internal controls. Based on a 2007 study by Financial Executives International, the average filer incurred outside audit and legal fees associated with Sarbanes-Oxley compliance of $846,000. The costs of compliance with 404(b) were clearly beyond the reasonable reach of smaller public companies.  Smaller public companies comprise approximately 50% of all public companies in the United States.

Stay tuned – the real financial reform will be published over the next few months and years.

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This is the first in a series that will analyze important changes to capital markets and corporate finance laws, enacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Most U.S. based companies seeking to raise money from investors do so through a “private placement” authorized under Regulation D of the Securities and Exchange Commission.  Reg D provides several exemptions from SEC registration of a securities offering, the most popular of which (Rule 506) allows unlimited investment and participation by “accredited investors”.  If the offering includes non-accredited investors, the issuer must meet required disclosure obligations by providing information of the same kind that would be provided in a registration statement for a public offering.  If only accredited investors participate in the offering, there are no specific disclosure requirements mandated by Reg D (although thorough disclosure is still recommended as a risk management practice).  Therefore, many issuers chose to limit their offerings only to “accredited investors”.

With the enactment of Dodd-Frank, effective July 21, 2010, and for at least the next four years, the definition of “accredited investor” has changed.  The net worth part of the accredited investor test, which specifies that a natural person is an accredited investor if his or her net worth is at least $1 million, now excludes the value of that person’s primary residence.   Before July 21, the net worth test included the investor’s primary residence.

There was no transition period or future effective date, so that issuers conducting private placements on July 21, 2010 had to amend and re-document their private placements in process to comply with the change.   Fortunately, the other portions of the accredited investor definition, including the net income tests for natural persons, remain unchanged for now.

The Comptroller General is required to study the appropriate criteria for accredited investor status and report back to Congress within three years.  On July 20, 2014 and every four years thereafter the SEC must review the definition of accredited investor as it applies to natural persons and make adjustments in the rules if appropriate.

The Race to the Bottom has a discussion of the history of the definition of accredited investor, as well as some thoughts about the SEC’s role in developing the standards in the past and the future.

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I will be presenting “Avoiding Land Mines on the Road to Success; Review of Federal & State Security Laws and legal aspects of Real Estate Investments” to the Denver Metro Commercial Association of REALTORS®. The talk will be from 8:00 a.m. to 10:00 a.m. on Thursday, May 27, 2010 at the DMCAR offices, 4300 E. Warren Ave., Denver, CO 80222. We will be discussing securities laws and private placement rules as they apply to real estate investment ventures, and I will be providing a review of some recent enforcement and fraud actions by the Colorado Securities Commissioner in real estate matters.

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A recent Colorado case emphasizes the risks of using unregistered and unlicensed “finders” to sell securities in private placements.  A “finder” is a person who is not registered with the Securities Exchange Commission or any other regulatory authority, but who nevertheless assists in the sale of securities.  Use of “finders” to sell securities in a private placement is always risky, because it is difficult to monitor and control their activities. 

The facts in Black Diamond Fund LLLP v. Joseph provide a what-not-to-do checklist for every entrepreneur or business owner trying to raise money through a private placement.  Black Diamond Fund (“BDF”) was an investment vehicle managed by Wealth Strategy Partners and Harvey Altholtz of Sarasota, Florida.  BDF offered $10 million in unregistered partnership interests in reliance on the private placement exemptions from registration provided by federal securities law.  Mr. Altholtz testified that BDF offered the limited partnership interests through a network of at least 50 “finders” nationwide, 5 of whom were in Colorado.  BDF paid a 5% finders fee to each finder upon completion of a sale.

The Private Placement Rules

It is illegal to sell securities in the United States without registering the securities with the SEC and state securities commissions, unless the sale is within an applicable exemption from registration – commonly known as a private placement exemption.  However, a “private placement exemption” is not found in one simple rule.  Rather, a variety of rules, regulations and SEC guidance must be followed to successfully conduct a private placement.  For example,

  1. the securities must be sold privately (hence, “private placement”), and
  2. the persons selling the securities must be either
    1. registered and licensed as broker-dealers or investment advisers, or
    2. exempt from registration. 

Failure to meet any one requirement can mean the loss of the private placement exemption for the entire offering.  Loss of the exemption gives all of the investors the right to rescind the investment and get their money back (often with attorneys’ fees), and leaves the issuer and its directors and officers vulnerable to legal action from federal and state securities commissions.  Moreover, securities liability is usually personal liability to the individuals involved; which brings us back to BDF and Mr. Altholtz.

Facts of the Black Diamond Case

One of BDF’s Colorado “finders” was William Gay.  Altholtz testified that he knew Mr. Gay had some trouble with the SEC (a wildly waving red flag Mr. Altholtz ignored), but he did not know that Gay was permanently barred from associating with any registered broker-dealer, that the Colorado Securities Commission had revoked his investment advisor license, and that the Denver District Court had issued a permanent injunction prohibiting Gay from associating in any capacity with any person or company involved in selling securities in Colorado.

Mr. Gay’s modus operandi was the proverbial “free lunch”, and an occasional free dinner.  Gay invited people to “investment seminars” where he would feed them both food, and investment advice that pointed to investments in BDF.  The invitations were sent to Colorado residents by mail. Gay had no preexisting relationship with many of the people he invited to the lunch and dinner “seminars”, and the invitations urged the recipients to “feel free to invite a friend”. The seminars were presented by both Gay and Altholtz.

For a placement to be private it cannot be offered to the public – it can only be offered to people the offeror already knows.  If the securities are marketed to the public, it is not a private placement, and the private placement exemption is lost.  Obviously, mass mailing invitations to potential investors is public advertising – not a private offering.

If the public solicitations were not enough, Gay also took an active part in selling the partnership interests.  He discussed the BDF opportunity with investors, obtained signed subscription agreements, and collected payment, which he sent on to Altholtz, who paid Gay a 5% commission.  If a finder is actively involved in an offer or sale, and is not a registered broker-dealer or investment adviser, then the securities were sold by an unregistered and non-exempt person and the private placement exemption is lost.

Finally, the court held that the fact that Gay was barred and enjoined from selling securities or associating with those who do was a material fact that should have been disclosed to investors, and since Altholtz knew or should have known that fact and failed to disclose it, Altholtz was liable for securities fraud.

In the end, Altholtz and BDF were liable for selling unregistered securities without an exemption, using an unregistered broker-dealer, and for securities fraud.

No Free Lunch

There is no free lunch when issuers allow finders to help them sell securities.  The use of even one unlicensed and unregistered finder is risky, and the issuer and its officers and directors can be liable for the finder’s acts.  Before agreeing to pay anyone who is not a registered broker-dealer or investment adviser to assist in a private placement, issuers should consult with experienced securities counsel to fully understand the risks and limitations.

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The Securities and Exchange Commission is establishing a new fellows program to help the Office of Risk Assessment keep track of complex securities and finance industry practices.  The SEC fellows programs has successfully paired the SEC with accountants and business people in the past to bring an outside perspective and professional expertise to the SEC.  The financial industry fellows will help the SEC stay abreast of evolving finance and securities industry practices, with the intent of strengthening the SEC’s security market oversight.  The SEC is looking for people with extensive experience in trading, structured products, complex derivatives, fund management, financial analysis and investment banking.

Applications are due by June 1, 2009.  A statement of qualifications and duties is available from the SEC.

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