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.

Sources:

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.

Sources:

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.

Sources:

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.

Sources:

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.

Sources: 

Compliance Bricks and Mortar for December 16

These are some of the compliance-related stories that recently caught my attention.

An Insider-Trading Ruling that Delights Prosecutors – And One Manhattan Judge by Roger Parloff in The New Yorker

Last week, prosecutors rejoiced when the U.S. Supreme Court decided an insider-trading case called Salman v. United States, and in doing so clarified that leaking confidential information so that friends and relatives can make money in the stock market is a crime, even when the leaker doesn’t get an economic benefit. Perhaps the person most pleased with the decision, however, was not a prosecutor but a certain white-haired Manhattan judge with a neatly trimmed, white beard. [More…]

US v. Newman – Not Quite Dead Yet by Gregory Morvillo in NYU Law’s Compliance & Enforcement

Last week the Supreme Court handed down a unanimous opinion in United States v. Salman.  It was a highly anticipated opinion by those of us who follow the evolution of insider trading law … and yes I recognize that following insider trading law is, at the least, a little bit geeky.  Nevertheless, many observers eagerly awaited the Supreme Court’s ruling.  As it turned out, the ruling was kind of a dud. [More…]

Trump’s businesses could trip insider-trading law by Isaac Arnsdorf in Politico

When Trump told the New York Times “the president can’t have a conflict of interest,” he was probably referring to the Ethics in Government Act, which exempts the president, vice president, members of Congress and judges, according to Brett Kappel, an attorney at the law firm Ackerman who specializes in politics and ethics. But the text of the STOCK Act explicitly includes the president. [More…]

This Weird United Airlines Case Just Happened by Matt Kelly in Radical Compliance

I speak of the SEC’s recent sanction against United Airlines, where the agency applied the spirit of the Foreign Corrupt Practices Act to a bribe United gave to a domestic government official here in the United States. That violation of United’s internal policies against bribery then became a books-and-records violation of the Securities Act, and presto: a $2.4 million fine against United on Dec. 2. [More…]

 

Compliance and Conflicts with Exxon Mobil and the Trump Administration

President-Elect Trump has many conflicts of interest as he prepares to take office. It’s been a long time since the president-elect has been so deeply involved in a active businesses. His appointment of Rex Tillerson as Secretary of State creates another batch of conflicts for the administration and for Exxon-Mobil.

As is typical with many public companies, Exxon-Mobil grants large chunks of deferred compensation to its executives. Mr. Tillerson is eligible for $175 million is stock compensation when he turns 65 in March.

The board of directors of Exxon is faced with a tough choice of granting the compensation early, before he becomes Secretary of State. That would deviate from company policy and be perceived as granting a favor as he assumes one of the most powerful posts in government.

This is not new territory. Halliburton suffered a big loss in reputation when it granted early retirement to Dick Cheney when he was elected vice-president.

If it does not grant early vesting, then Exxon will be in the position of granting a fortune to the Secretary of State while in office.

Although Mr. Trump controls his organization and can largely do what he wants at whim, Exxon is a public company and subject to tigher rules on what it can do. According to the 2016 proxy statement, Mr. Tillerson held almost 2 million shares in the company. He was granted another $18 million in stock at the end of 2015.

Sources:

What Kind of Car Does Your Fund Manager Drive?

In a new paper, researchers found that hedge fund managers who own powerful sports cars take on more investment risk and are more likely to engage in fraudulent behavior. The inverse is also true: Drivers of minivans tend to deliver less volatile returns, according to the study.

“Specifically, sports car drivers deliver returns that are 1.80 percentage points per annum more volatile than do non-sports car drivers. This represents a 16.61 percent increase in volatility over that of drivers who shun sports cars. Similarly, drivers of high horsepower and high torque automobiles exhibit 1.14 and 1.25 percentage points per annum more volatility, respectively, in the funds that they manage than do drivers of low horsepower and low torque automobiles.”

The researchers used four sets of hedge fund databases from 1994 to 2012 that included 58,068 hedge funds, of which 33,680 are still in existence. Then they tapped into vehicle purchase databases to try to match fund managers to their cars. Thye ended up with a set of 1774 vehicles to 1,144 hedge managers. Of those, they identified 163 sports cars and 101 minivans.

I’m a bit skeptical of the studies methodology at this point given how they have narrowed down the set to be studied.

But I continued on to the operational, and complaince aspects.

The study found that sports car drivers are 17.3% more likely to have a violation report on their Form ADV than the owners of other cars. Minivan owners are 44.6% less likely to a violation reported on Form ADV.

Some of this is attributable to marriage status. Minivan drivers are much more likely to be married. After looking at the impact the study still found that the results are not just a by-product of marriage.

Given limited complaince budgets, perhaps it may be useful on the next compliance report to ask your employees what kind fo car they drive to help you focus your compliance efforts on the sports card drivers.

Sources:

The Duchess and the Mouse Hole Cheat for Russian Athletes

Widespread cheating by Russian athletes has been uncovered. One of the key figures was Russian Dr. Rodchenkov who had breakthrough work on the detection of peptides and long-term metabolites of prohibited substances.

In the jargon of espionage, Dr. Rodchenkov was a double agent. While operating at the forefront of doping detection, he was secretly developing a cocktail of drugs with a very short detection window.

The doping was referred to as “Duchess.”

This was in connection with the mouse hole breach in the testing facility. In the dead of night, Russian officials exchanged the tainted urine from their athletes who had been doping with clean samples by passing them through a “mouse hole” drilled into the wall of the anti-doping lab.

The bottles were supposed to be tamper-proof. The Russian agents were able to open the tamper-proof bottles and replace the contents without detection. Upon closer inspection, investigators were able to identify bottles that were tampered with by identifying scratches on the inside of the bottle caps.

695 Russian athletes can be identified as benefiting from the manipulation to conceal potential positive doping controls. They have not yet been identified.

The reports reveals that the Russian Ministry of Sport manipulated the doping control process of the 2014 Sochi Games; the 2013 IAAF World Championships in Moscow; the 2013 World University Games in Kazan; and, put measures in place to circumvent anti-doping processes before the 2012 London Games.

Sources: