The SEC Really Means It About Pretaliation Severance Agreements

In case you were not clear that the Securities and Exchange Commission is serious about enforcing Rule 21F-17, BlackRock is the latest to run the perp walk. The SEC accused the money management giant of improperly using separation agreements that forced employees to waive their ability to obtain whistleblower awards.

The SEC adopted Rule 21F-17, which provides in relevant part:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Rule 21F-17 became effective on August 12, 2011.

On October 14, 2011, BlackRock revised its form separation agreement. That agreement did not prohibit former employees from communicating directly with the SEC or any other governmental agency regarding potential violations of law. It did include language requiring a departing employee to waive recovery of incentives for reporting misconduct. Effectively, the agreement removed the financial incentive to be a whistleblower.

Paragraph 5 of BlackRock’s separation agreement in use from October 14, 2011 through March 31, 2016 stated in relevant part:

“To the fullest extent permitted by applicable law, you hereby release and forever discharge, BlackRock, as defined above, from all claims for, and you waive any right to recovery of, incentives for reporting of misconduct, including, without limitation, under the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Sarbanes-Oxley Act of 2002, relating to conduct occurring prior to the date of this Agreement.”

Over 1000 departing employees signed separation agreements with this language. BlackRock revised the agreement in March 2016 to remove that provision. BlackRock also produced a “Global Policy for Reporting Illegal or Unethical Conduct” that it distributed to employees and provides yearly training.

In the end, BlackRock a penalty of $340,000.

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SEC’s 2017 Exam Priorities

Last week the Securities and Exchange Commission issued the 2017 priorities for the Office of Compliance Inspections and Examinations. There are five main items on the list, plus some others. Private funds are still on the list.

Retail Investors –

  • Roboadvisers
  • wrap fee programs
  • ETFs – redemption and sales practices
  • Never-before examined
  • Recidivist
  • Multi-branch -(Are your smaller branches as compliant as the main office?)
  • Share class selection

Senior Investors and Retirement Investments

  • Continuing the multi-year ReTIRE initiative, focusing on investment advisers and broker-dealers along with the services they offer to investors with retirement accounts.
  • Variable insurance products
  • Target date funds
  • Public pension plan advisers. “We will examine investment advisers to these entities to assess how they are managing conflicts of interest and fulfilling their fiduciary duty. We will also review other risks specific to these advisers, including pay-to-play and undisclosed gifts and entertainment practices.

Market-Wide Risks

  • Money market funds under the new rules.
  • Payment for order flow programs
  • Clearing agencies
  • Regulation SCI and anti-money laundering rules

FINRA – Consistent with OCIE’s goal of enhancing oversight of FINRA to protect investors and the integrity of our markets, it will continue conducting inspections of FINRA’s operations and regulatory programs, and focus resources on assessing the examinations of individual broker-dealers.

Cybersecurity – OCIE will continue its ongoing initiative to examine for cybersecurity compliance procedures and controls, including testing the implementation of those procedures and controls at broker-dealers and investment advisers.

In addition to those big ones, OCIE is continuing to look at municipal advisors, transfer agents and private fund advisers.

“We will continue to examine private fund advisers, focusing on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors.”

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A New Level of Compliance Officer Concern: Getting Arrested

Oliver Schmidt is the former top emissions compliance manager for Volkswagen in the United States. The FBI arrested him on Saturday as part of the Volkswagen emissions scandal. He was denied bail, pending a court appearance later this week.

Perhaps, the case is not one of a compliance officer missing a problem, but a compliance officer actively engaged in the wrongdoing. The charges are for conspiracy to :

  1. Defraud the US by impeding the EPA’s function of approving certificates of conformity for vehicles
  2. Commit wire fraud
  3. Violate the Clean Air Act

In this case, it looks like Schmidt was involved in the wrong-doing and the cover-up according to the criminal complaint.

One piece of evidence was that Mr. Schmidt produced a slidedeck regarding the emissions problem. In a meeting with the California Air Resources Board he identified two outcomes: 1- positive, then VW gets approval for 2016 model cars; 2-no explanation for the emission problem=indictment. I’m guessing, he may not have realized that indictment would be aimed at him.

Schmidt was a manager in charge of the Environmental and Engineering Office which is the group in VW that is responsible for communicating and coordinating with regulators. That sounds like a compliance role, but not in the way that most compliance professionals think of the role.

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The New Administration’s Pick for the Chair of the SEC

Wall Street lawyer Jay Clayton is slotted to head the U.S. Securities and Exchange Commission in the Trump administration.

This is a big change from Chair White whose background was in prosecution. Chair White had a long list of prosecutions from serving a decade as the U.S. Attorney for the Southern District of New York. (She is the only woman to have held that position.) Then served another decade as a litigator in private practice.

Mr. Clayton has a wide-ranging corporate practice spanning mergers and acquisitions, IPOs, corporate governance, and investment advice. He is respected lawyer and will likely do a great job with the SEC.

But he is a very different kind of lawyer than Ms. White. He is a deal lawyer, largely working on corporate transactions and governance.

Perhaps that marks a change in the SEC from one of enforcement to one of enhancing the capital markets. Chair White was saddled with the rule-making imperatives from Dodd-Frank. With most of those in place, the SEC will have more bandwidth to focus its agenda. The appointment of Mr. Clayton seems to be an indication that the SEC may focus more on the other prongs of its mission: maintain fair, orderly, and efficient markets, and facilitate capital formation.

The front page of the Wall Street Journal laments the loss of public companies: America’s Roster of Public Companies Is Shrinking Before Our Eyes. I think most people are guessing that Mr. Clayton will try to fix that issue.

With the appointment of Mr. Clayton, that still leaves two open slots to be filled. No word on whether the stalled nominations of Lisa Fairfax and and Hester Peirce will proceed or whether there will be new candidates.

The Latest Word on the SEC’s Administrative Judges

There have been several challenges to the constitutionality of the in-house administrative judges at the Securities and Exchange Commission. The problem is that the judges are appointed by an internal panel instead of by the President or the SEC Commissioners. The SEC has fended off attacks. Now there is break in wall. The 10th Circuit found the use to be unconstitutional.

The Constitutional question is whether the SEC’s ALJs are “Officers of the United States,” including principal and inferior officers, who must be appointed under the Appointments Clause. U.S. Const. art. II, § 2, cl. 2.

For some reason, the SEC does not appoint the ALJ’s directly. If it did so, it could probably erase this problem going forward. I assume the legal advice is that the change would put past cases into jeopardy.

In August, the U.S. Court of Appeals for the D.C. Circuit in Raymond J. Lucia Cos. v. SEC, accepting the SEC’s argument that ALJs are mere “employees,” and not officers at all. This seemed to be the accepted stance when the US Supreme Court in September denied hearing the appeal of Lynn Tilton in her case arguing on roughly the same issue.

The 10th Circuit Court of Appeals came to the opposite conclusion last week in  Bandimere v. SEC. The Bandimere may differ slightly from prior cases. Unlike some of the other attacks, Mr. Bandimere raised the constitutional question before the SEC, which rejected it. The 10th Circuit put the other attacks in the bucket of collateral lawsuits attempting to enjoin the administrative enforcement actions.

The 10th Circuit, based on Freytag v. Commissioner of Internal Revenue, 501 U.S. 868 (1991), concluded that the SEC ALJ who presided over an administrative enforcement action against Mr. Bandimere was an inferior officer who was not constitutionally appointed. The Freytag analysis has three parts to determine if an ALJ is an “inferior officer”:

(1) the position of the SEC ALJ was “established by Law,”;

(2) “the duties, salary, and means of appointment . . . are specified by statute,”.; and

(3) SEC ALJs “exercise significant discretion” in “carrying out . . . important functions,” .

The Bandimere decision rejected the argument in the Lucia case that ALJs do not have final decision-making power. They have enough power to make them an “inferior officer.”

I would place a bet that the SEC will appeal this case to the Supreme Court. Given the split in the circuit courts of appeal, it makes the case more likely to be heard.

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Draining the Swamp?

One of the rallying cries for President-elect Trump was to drain the swamp of corruption. Compliance professionals could think of many things that could happen to remove conflicts or the appearance of conflicts.

Personally, as a compliance professional and a voter, I was disappointed to learn that Hillary Clinton did a poor job of walling off donations to the Clinton Foundation from her role as Secretary of State. If she had established a clear protocol, she could have easily dismissed the charges that donors were paying to gain access.

It is even more disappointing to hear President-elect Trump dismiss the concerns about conflicts between his sprawling business empire and his role as president. There are a little over two weeks until he steps into office and there has been little to show that he has taken material steps to remove the conflicts.

The latest muck in the swamp is Congress eviscerating the independent Office of Congressional Ethics.

Compliance professionals spend a great deal of energy to have independence for reviewing programs and conducting investigations. Direct contact with the board of directors allows compliance to avoid company executives from stifling a problem.

Under the ethics change pushed by Rep. Bob Goodlatte, R-Va., the non-partisan Office of Congressional Ethics would fall under the control of the House Ethics Committee. That committee is composed of sitting members of Congress, five Republicans and five Democrats.

Given the new rules, any investigation can be shut down along party lines before a review has begun.

It’s not that the OCE was fully independent. It was not authorized to sanction members, officers or employees of the House. The Ethics Committee has exclusive authority to determine if a violation has occurred and what the sanction should be. The rule change allows an investigation to shut down before it gets any traction.

This is not a theoretical problem. Through the third quarter of 2016, the OCE started 35 reviews which led to 17 referrals to the House Ethics Committee for review for the 114th Congress.

It sounds like there is little draining of the swamp and more like the swamp is filling up.

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Return of the Whistleblower

It’s been a busy week for whistleblower cases. The latest is a case against SandRidge Energy for using severance agreements that impeded employees from contacting the Securities and Exchange Commission.

In response to Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Sandridge’s severance agreements stated that the former employee could not

at any time in the future voluntarily contact or participate with any governmental agency in connection with any complaint or investigation pertaining to the Company, and [may] not be employed or otherwise act as an expert witness or consultant or in any similar paid capacity in any litigation, arbitration, regulatory or agency hearing or other adversarial or investigatory proceeding involving the Company.

A second provision had the former employee agree  “not to make any independent use of or disclose to any other person or organization, including any governmental agency, any of the Company’s confidential, proprietary information unless [the employee] obtain[ed] the Company’s prior written consent.”

A third provision required the former employee to “not at any time in the future defame, disparage or make statements or disparaging remarks which could embarrass or cause harm to SandRidge’s name and reputation or the names and reputation of any of its officers, directors, representatives, agents, employees or SandRidge’s current, former or prospective vendors, professional colleagues, professional organizations, associates or contractors, to any governmental or regulatory agency or to the press or media.”

Three bad provisions cost SandRidge $1.4 million.

Not really SandRidge. It’s in bankruptcy. It’s creditors are going to have add this unsecured claim in the bankruptcy proceedings.

SandRidge caught the attention of the SEC because it had included a severance agreement in an SEC filing. The SEC asked the company to change the agreements and it did so. But there were still a few hundred agreements out there.

Including for one employee that the SEC tried to interview to discuss his departure. He cited the severance agreement as a reason he was unable to speak with the SEC. The bad language turned from a technical violation into an actual impediment.

It turns out that the employee had serious concerns about how SandRidge was calculating oil and gas reserves. The company ended up firing him on April 1, 2015. While negotiating the severance agreement his lawyer asked for the unlawful provisions to be removed. This was two month after the KBR case on unlawful severance agreements.

SandRidge makes four cases over the past 18 months on severance agreements that violate Rule 21F-17.

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The SEC Strikes Back Again on Whistleblower Pretaliation

Compliance officers need to take a look at severance agreements. The Securities and Exchange has blown up another company for including provisions in its severance agreements that may have impeded employees from communicating information to the SEC.

NeuStar Inc. used severance agreements that contained a broad non-disparagement clause forbidding former employees from engaging “in any communication that disparages, denigrates, maligns or impugns” the company. Former employees could be compelled to forfeit all but $100 of their severance pay for breaching the clause.

In response to Dodd-Frank, the SEC adopted Rule 21F-17 in August 2011, which provides:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

Among the investors, customers, competitors and other parties listed in the non-disparagement clause, NeuStar specifically included the Securities and Exchange Commission. That makes it a bad agreement and in violation of Rule 21F-17.  From August 2011 to May 21, 2015, NeuStar used the bad severance agreement for 246 employees. The SEC order indicates that at least one ex-employee wanted to talk to the SEC, but was impeded by the agreement.

This is the third pretaliation case from the  SEC, following up on KBR and BlueLinx.

In each case, the offending company was required to reach out to the ex-employees and let them know that the company was not preventing them from talking to the SEC. It seems clear that the compliance officers may want to spend some time this holiday season looking through their severance agreements to see if they could be construed as limiting the employees from talking to the SEC. If so, you may want to send a holiday card granting those employees a holiday wish to talk to the SEC.

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Co-investments and Conflicts

I have seen a few indications from the Securities and Exchange Commission showing that examiners are concerned about co-investments. I have yet to see a large over-arching activity in the industry that has been identified as problematic. I saw an action last week for a fund advisor related to co-investments so it caught my eye. Upon closer inspection, the issue was less one of co-investments and more one of an affiliate transaction.

New Silk Route Advisors is registered as an investment advisor. It manages two private equity funds that primarily invest in India. those funds invested in four companies along side another unnamed fund.

That unnamed fund was managed by a separate registered investment advisor. That advisor was run and co-founded by the same person who ran and co-founded New Silk Route Advisors.

The SEC claims that the fund documents for the New Silk Road funds treated that unnamed fund as an affiliate and therefore the co-investments were affiliate transactions. According to the fund documents, New Silk Road should have disclosed the co-investments to the fund boards of advisors and obtained approval.

The misstep resulted in a fine of $275,000.

The charge does cite any specific harm to investors in the New Silk Route funds. It does note that the unnamed fund ran out of capital and was not able to make a follow up investment in one company. New Silk Route stepped in and contributed the additional capital and took a bigger chunk of the company. At the time of the unnamed fund’s dilution, New Silk Route sought the board of advisors approval for the co-investments.

Adding in a related party does create many concerns, especially if the funds have different timelines and different investment styles. It was sloppy to not treat this an affiliate transaction and seek approval.

According to my tally, these are the cases that the SEC has publicized on co-investment problems:

  1. New Silk Road – failing to treat a co-investment with an affiliate as an affiliate transaction
  2. Co-investment allocation – No cases, but concerns about luring investors with co-investments and not making them available.
  3. Improper allocation of broken deal costs with co-investments – KKR

Let me know if you aware of others.

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