White-Collar to Blue-Collar in One Day

Last week, the U.S. Supreme Court issued two notable decisions on the same day.

One was a civil white-collar case, the other a criminal drug-trafficking case, and in both cases, the Court reversed the lower-court ruling on appeal.

In the civil case, the Court imposed a five-year statute of limitations on SEC cases that seek to disgorge profits. That’s the same period that applies in cases to enforce a fine, penalty, or forfeiture. Although disgorgement of profits is traditionally a form of restitution that’s measured by a defendant’s wrongful gain, the Court ruled that it’s a penalty in SEC cases for a couple reasons. First, the agency uses it to deter and punish defendants as much as to compensate victims. Sometimes, the money goes to Uncle Sam, and sometimes, the only victim is the public at large. Second, the agency often disgorges more than defendants have gained, leaving them worse off than before they broke the law. That may be the point, but that makes it a penalty.

In a footnote, the Court even seemed to call into question whether courts could order disgorgement at all. That’s something they’ve been doing since the 1970s, so it’s a big deal. For more in-depth analysis of this decision, see here.

In the criminal case, the Court reined in the government’s forfeiture power. Forfeiture allows the government to seize money or property that’s derived from a crime. But the law limits this to what someone actually and personally receives or obtains. That means you can’t be responsible for amounts obtained by someone else. So the hypothetical college student who gets $500 per month to drop off a few packages isn’t on the hook for the whole multimillion-dollar drug enterprise.

Here, two brothers worked in a hardware store together. One of them owned the store, and the other was a salaried employee. The two were charged with selling large amounts of a product they knew or had reason to know was being used to make meth. In three years, the store grossed about $400,000 from selling the stuff and netted $270,000.

The government wanted the $270,000 in profits. The owner agreed to forfeit $200,000 of it when he pleaded guilty, but the employee went to trial. He was acquitted of three counts, convicted of eleven, and sentenced to sixty months in prison. Then the government went after him for the remaining $70,000.

Although the government agreed that the employee had no ownership interest in the store and didn’t personally benefit from the illicit sales, it argued that, in a conspiracy, everyone is responsible for the full proceeds of the conspiracy. And it won that argument on appeal.

But the Supreme Court rejected that and reversed.

 

SEC Lights Up Another Cannabis Company

In what may be a sign of maturity for the industry, the Securities and Exchange Commission has sued another marijuana-related business for violating federal securities laws.

Last month, the SEC charged a California-based company and two former executives with a classic pump-and-dump scheme. First, the Commission says, the defendants touted phony revenue to drive up the price of the company’s stock. Then they unloaded their own shares for millions of dollars. According to the complaint, much of the revenue came from a series of sham transactions with a shell company that the executives controlled. So the SEC charged them with fraud as well as offering and selling unregistered securities.

The company and one of the executives have settled the case without admitting or denying liability. The executive agreed to pay more than $12 million, among other penalties.

Meanwhile, the company has turned over a new leaf, so to speak, overhauling its management, business model, and board of directors.

The SEC will continue to scrutinize the market, however, which highlights something cannabis companies should already know: get your ducks in a row, and run your business the right way.

Puff and pass if you want, but don’t pump and dump.

Securities Fraud: But Was It Even A Security?

What is a security, anyway? The California Court of Appeal tackled that question recently in a case about a loan between friends.

A good starting point is that the law considers a security to be an investment contract, but there’s more to it than that. You may be familiar with common examples like publicly-traded stocks and bonds, but sometimes it’s a tougher call.

California law recognizes two tests to determine whether a deal or transaction is a security. One is the state’s risk-capital test, and the other is the federal Howey test (from a U.S. Supreme Court case). California courts may apply either one to your case, their goal being to protect the public from shady investment schemes.

The narrower risk-capital test asks whether you indiscriminately solicited passive investments from the public at large. A passive investment is one whose success depends mainly or exclusively on the efforts of people other than the investors.

The broader federal test simply asks whether you solicited people to invest passively.

In this case, the defendant had persuaded a guy he knew to invest in his land-development deal. The investment was a $280,000 promissory note that promised to pay out as follows:

  1. If the land were sold, the guy would share in the net profits from the sale.
  2. If the land were developed, he would receive one residential acre of his choosing.
  3. If neither event took place within one year, he could call the note and get interest on top of principal at a rate of ten percent.

But things didn’t exactly pan out, and some years later, the local district attorney’s office charged the defendant with securities fraud.

The trial court partly dismissed the case because it ruled that the promissory note wasn’t a security but a simple loan.

The government appealed that ruling, but the appeals court agreed. Even under the federal test, the note wasn’t a security because it was carefully negotiated between the parties, and it called for repayment whether the venture succeeded or not. The defendant had even personally guaranteed it.

So the case could’ve been a breach of contract, or it could’ve been a fraud.

But it wasn’t a securities fraud because the note wasn’t a security.

Much Ado About Little

The U.S. Supreme Court decided its big insider-trading case of the term on Tuesday, and it turns out you still can’t toss a friend or family member a tip to trade on. Who knew?

Here are the facts. The defendant’s brother-in-law was an investment banker who advised major healthcare companies on mergers and acquisitions. Over time, he shared inside information about these corporate deals with his biological brother, who shared them with the defendant. By the time of defendant’s trial, the brothers had both pleaded guilty, and they testified that defendant knew the tips came from insider trading.

Well, the jury convicted him, and on appeal, he relied on a recent case out of New York that we wrote about here.

Under that case, he argued, insider trading required proof that the insider benefited financially from the tipping. In his case, however, the insider (banker) had tipped off his brother freely as a gift. Therefore, none of it was insider trading.

The problem was that the New York case didn’t say that. While insider trading does require the insider to benefit personally from the tip, the law has long defined such personal benefit to include the benefit you get from making a gift of confidential information to a relative or friend. The New York case didn’t change that, though it did question who should count as a friend (or relative, for that matter) in a world full of loose connections.

Still, the New York case had caused a stir in the white-collar-defense world over whether the Supreme Court would use this case to reshape the law of insider trading.

But this case was different, and the Court did no such thing.

SEC Reports Enforcement Results for 2016

As we wind down the calendar year, the Securities and Exchange Commission has already reported its enforcement results for the fiscal year that ended September 30.

In case you missed it, here’s the press release. Naturally, there’s some self-patting on the back, but if the past predicts the future, the agency is looking to file cases. Its numbers have climbed steadily over the last dozen years, and it continues to ramp up its use of big-data analytics and the whistleblower program, which it launched in 2011.

Here are some highlights from 2016.

  • The agency filed a total of 868 cases, which was a new single-year high.
  • It filed a record number of cases involving investment companies or advisers and a record number under the Foreign Corrupt Practices Act.
  • It obtained over $4 billion in judgments and orders, which matched the haul from each of the last two years.
  • It awarded more money to whistleblowers ($57 million) than in all prior years combined.

What Are Your Intentions?

In most white-collar cases, the main driver at sentencing is the dollar amount of the victim’s loss, and in federal cases, the rule is that you’re responsible for either the actual loss or your intended loss, whichever is greater. We touched on the difference between actual and intended loss in this post from last spring.

But recently, an influential federal court of appeals had to decide a case in which the defendant stole his employers’ trade secrets but didn’t actually cause or intend any loss.

How so?

The defendant was a young financial analyst who, over a two-year period, worked for two securities firms. Both firms had created computer software to engage in high-frequency trading, where a computer trades at lightning-fast speed in response to market events. Each firm had invested time and money to develop the algorithms behind its software.

The defendant pleaded guilty to copying their computer programs for his own use, but he didn’t sell them, publish them, or take them to a competitor.

Instead, he used them to start making computerized trades himself, and he lost $40,000 in the process. There was no evidence he had any bigger plans for them than that. He got caught when the second firm grew suspicious of the activity on his work computer, which led to his being indicted for wire fraud, computer hacking, and theft of trade secrets.

At sentencing, everyone agreed that the two firms had suffered no actual loss, and there was no evidence the guy intended to cause them any loss at all.

The trial court, however, found that he intended to cause a loss of $12 million because that was the total labor cost that the firms incurred in developing their software.

That number made a big difference. Under the federal sentencing guidelines, it jacked up the guy’s suggested sentence from probation, which may have included some time in home detention or a halfway house, to a sentence of seven to nine years in prison. Based on that, the court sentenced him to three years in prison.

And yet, there was no evidence that the guy intended to cause the victims any loss, let alone a loss that equaled their internal cost of development. Although the trial court could consider such costs under the sentencing guidelines, it could not base its loss estimate on those costs alone without any proof of the defendant’s intent.

So the court of appeals sent the case back for resentencing.

CFTC Launches New Website for Whistleblowers

Another thing about the Commodity Futures Trading Commission: Last month, the agency unveiled the new website for its whistleblower program at www.whistleblower.gov. It looks pretty good, and it’s easy to navigate. It tells you what you need to know about the program, including how to submit a tip and how to apply for an award.

The CFTC’s whistleblower program was created by the Dodd-Frank Act of 2010, and it provides monetary awards to people who voluntarily report violations of the Commodity Exchange Act. If your tip translates into an enforcement action that results in more than $1 million in sanctions, you stand to receive 10-30 percent of the money collected. The pay out may even include money collected by other agencies that piggyback off your successful tip.

Here’s the CFTC’s press release.

Meanwhile, the agency has apparently caught flak for the way it’s been accounting for its office leases, though after a year-long audit by the Government Accountability Office, it seems like much ado about little.

You can read a couple stories about it here and here, but after reviewing the GAO’s report, it’s hard for me to see the point of the whole exercise unless it was to fuel congressional squabbles over the CFTC’s budget.

And for my money, an agency that we’ve called on to regulate the multi-trillion-dollar derivatives markets needs a lot more than $250 million per year to do its job.

The CFTC’s First Ever Case of Insider Trading

Two months ago, for the first time, the Commodity Futures Trading Commission flexed its new anti-fraud powers under the Dodd-Frank Act to punish insider trading in the futures markets.

How so? The agency filed and settled an enforcement action against an employee whose job was to trade energy futures for a large corporation. Allegedly, the employee used access to confidential information about the timing, volume, and prices of the company’s trades to profit his own personal accounts at his employer’s expense. He allegedly executed trades between the company’s account and his personal accounts, thus playing both sides of the deal, and he allegedly placed other personal orders just ahead of orders he placed for the company, thus benefiting from price movements caused by the company’s much larger trades. These actions violated the Commodity Exchange Act and its regulations.

Under the terms of the settlement, the employee did not admit or deny the agency’s findings and conclusions, but he agreed to pay restitution in the amount of $217,000, a monetary penalty of $100,000, and post-judgment interest on both. He also consented to a permanent bar from trading in commodities directly or indirectly.

For more details, here’s a copy of the Commission’s press release, and here’s a copy of the order itself. For more in-depth analyses on what this may mean for the agency’s enforcement efforts going forward, see here and here.

The SEC Dodd-Frank Whistleblower Program

Speaking of whistleblowers, the Securities and Exchange Commission just published its annual report to Congress on its own program that it launched in 2011.

And overall, it seems to be on the upswing.

The SEC’s program authorizes monetary awards for volunteering original information that results in a successful enforcement action, including sanctions that exceed $1 million. It doesn’t matter whether you help open a successful investigation or close an existing one more efficiently or favorably.

If you fit the bill, you get ten to thirty percent of whatever the agency collects, and the percentage will vary with the facts and circumstances of the case. Factors that can raise your percentage include the value of your information, the overall assistance you provide, the public interests at stake, and whether you tried to report the matter internally (and suffered retaliation for it) before going to the government. Factors that can lower your percentage include your own unclean hands, if any, whether you delayed unreasonably in reporting the matter, and whether you interfered with your company’s internal compliance program (if any).

According to the report, since 2011, the Commission has paid over $54 million to 22 whistleblowers, and in the last fiscal year alone, it paid over $37 million to eight of them. One received over $30 million and another received over $3 million.

Who are they? According to the agency, about half are current or former employees of the companies they blow the whistle on. Others include ticked-off investors, industry peers, or personal contacts of the person or company in question. They hail from all fifty states as well as other countries, but most come from California, New York, New Jersey, Florida, and Texas. Many submit their information anonymously through counsel.

What do they report on? It runs the gamut, but often, they report on misstated corporate disclosures and financials; fraud in connection with securities offerings; price manipulation; insider trading; unregistered offerings; or violations of the Foreign Corrupt Practices Act.

The SEC’s Home-Court Advantage

As noted in a series of reports over the last year or so, the Securities and Exchange Commission has steadily been sending more of its cases, including contested cases, to be heard before its own, administrative judges rather than litigating them in federal court. The trend follows passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which amplified the agency’s ability to exact civil penalties in administrative hearings without having to sue in federal court.

According to the Wall Street Journal, the Commission won 90% of contested cases before its own judges from October 2010 through March 2015, compared to 69% of such cases in federal court. The agency did even better from September 2011 through September 2014, winning 22 of 23 cases before its judges, compared to 67% of such cases in federal court.

According to another, competing analysis, the agency won just 70% of the time before its own judges, but only if winning were defined as the agency’s running the table and getting everything it wanted. Otherwise, it did a lot better than that, and as far as actually losing, that happened in just six out of 359 cases, or less than 2% of the time.

Finally, on administrative appeals from these decisions, the Commission agreed with its own judges in 90% of cases from January 2010 through March 2015.

In response to all this, some defendants have filed constitutional challenges in federal court, some of which have gained traction. Other critics include business lobbies, federal judges, and even former agency officials, including one former SEC judge who says she retired under pressure from peers who questioned “her loyalty to the SEC” based on her decisions.

In rebuttal, the Commission has explained the spread in part by noting that many administrative cases are routine cases in which the outcome is not in doubt. These include defaults in which the defendant doesn’t bother to show up as well as cases limited to imposing administrative penalties after the defendant has already lost in court.

The criticism, however, may have struck a nerve.

Last month, the Commission proposed amendments to its procedures to align them more with the rules in federal court. These amendments, which the agency is soliciting public comment on through December 4, propose to do the following things among others:

  1. afford defendants up to eight months to prepare for a hearing in complex cases instead of the current four months;
  2. afford defendants the right to subpoena documents as well as depose up to three witnesses in complex, single-defendant cases or up to five witnesses in complex, multi-defendant cases;
  3. require the exchange of expert reports and disclosures before the hearing;
  4. introduce limits on the use of hearsay evidence; and
  5. set deadlines of eight to ten months for the agency to rule on appeals, which have dragged on in some cases.

Some argue these amendments don’t go far enough. They don’t give the defense enough time or discovery to work with; they don’t eliminate hearsay evidence altogether; and they don’t stop the Commission from hearing appeals on cases decided by its own judges.

Still, the criticism has struck a nerve. On Monday, the Wall Street Journal reported that the Commission has begun to curb its use of administrative judges in contested cases, and lately, it’s begun to lose more cases before those judges.

Even so, the words of one SEC official ring true: “Whatever forum we’re talking about, we win … the vast majority of the time.”

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