Friday, December 23, 2011

New York's Highest Court Holds That Martin Act Does Not Preempt Claims for Breach of Fiduciary Duty and Gross Negligence

In Assured Guar. (UK) Ltd. v. J.P. Morgan Inv. Management Inc., 2011 N.Y. Slip Op. 09162, 2011 WL 6338898 (N.Y. Dec. 20, 2011), the plaintiff, Assured Guaranty (UK) Ltd., commenced an action against defendant, J.P. Morgan Investment Management Inc., asserting causes of action for breach of fiduciary duty, gross negligence and breach of contract. The gravamen of the complaint was that J.P. Morgan mismanaged the investment portfolio of an entity whose obligations plaintiff guaranteed.

J.P. Morgan moved to dismiss the complaint, arguing that the breach of fiduciary and gross negligence claims were preempted by the Martin Act (New York's "blue sky" law). The Supreme Court granted the motion and dismissed the complaint. The Appellate Division modified by reinstating the breach of fiduciary duty and gross negligence causes of action and part of the contract claim. The Appellate Division granted J.P. Morgan leave to appeal.

J.P. Morgan's position was that plaintiff's common-law breach of fiduciary duty and gross negligence claims must be dismissed because they are preempted by the Martin Act. The Martin Act, argued J.P. Morgan, vests the Attorney General with exclusive authority over fraudulent securities and investment practices addressed by the statute. Therefore, J.P. Morgan contended, it would be inconsistent to allow private investors to bring overlapping common-law claims.

After reviewing the legislative history of the Martin Act, the court found that the plain text of the Act, while granting the Attorney General investigatory and enforcement powers and prescribing various penalties, did not expressly mention or otherwise contemplate the elimination of common-law claims. (citing ABN AMRO Bank, N.V. v. MBIA Inc., 17 N.Y.3d 208, 224 (2011) (stating that, if the Legislature intended to extinguish common-law remedies, “we would expect to see evidence of such intent within the statute”)). The court could find nothing in the legislative history that demonstrated a “clear and specific” legislative mandate to abolish preexisting common-law claims that private parties would otherwise possess.

The court acknowledged that New York courts had previously held that the Martin Act did not “create” a private right of action to enforce its provisions (citing CPC Intl. v. McKesson Corp., 70 N.Y.2d 268, 276-277 (1987)). However, the court found that the fact that “no new per se action was contemplated by the Legislature does not ... require us to conclude that the traditional ... forms of action are no longer available to redress injury” (citing Burns Jackson Miller Summit & Spitzer v. Lindner, 59 N.Y.2d 314, 331 (1983)). Hence, the court agreed with plaintiff that the Martin Act does not preclude a private litigant from bringing a nonfraud common-law cause of action.

J.P. Morgan pointed to past precedent which established that there was no common-law cause of action where the claim is predicated solely on a violation of the Martin Act or its implementing regulations. However, the court distinguished these cases by noting that an injured investor may bring a common-law claim (for fraud or otherwise) that is not entirely dependent on the Martin Act for its viability. In other words, the mere overlap between the common law and the Martin Act was not enough to extinguish common-law remedies.

Finally, the court found that policy concerns militated in favor of allowing plaintiff's common-law claims to proceed. The court agreed with the New York Attorney General that the purpose of the Martin Act is not impaired by private common-law actions that have a legal basis independent of the statute because proceedings by the Attorney General and private actions further the same goal—combating fraud and deception in securities transactions.

For all of these reasons, the court concluded that plaintiff's breach of fiduciary duty and gross negligence claims were not barred by the Martin Act. Accordingly, the court found that the order of the Appellate Division reinstating the breach of fiduciary duty and gross negligence causes of action and part of the contract claim should be affirmed.

Friday, September 23, 2011

TWEETING, POSTING, and FRIENDING: Social media’s two-edged sword for Investment Advisers

Regulators and compliance departments alike have been shaking their heads at the potential pitfalls of social media. How to support and allow Investment Adviser’s to use social media tools and still protect the investor from bad actors and misinterpreted posts or tweets is no easy task. The rapid fire tweets and the “share everything” mentality become permanent, potentially discoverable, records. But Investment Advisers are finding that social media provides valuable avenues never before available to share and gain information, to find new clients, and to better understand existing clientele.

This week, the Wall Street Journal had an article on this very subject. While little official guidance has been provided to Registered Investment Adviser firms on proper social media policies, reviewing the current guidelines for client communication can offer guidance to compliance and legal departments when they are requested to develop a road map for their firm and its social media policies. The potential pitfall in having a detailed policy is that once it is in black and white, it must be followed, and either an individual or a department must be charged with ensuring this—quite a task for a such a vast medium. However, given the free-range but permanent aspects of social media, RIA’s of all sizes should begin discussing and seeking legal counsel on how they will address this matter given the current regulations in place that govern client and potential client communications. The alternative--waiting for a post or a tweet to cause a problem--can be a dangerous course to take.

Additionally, many employees may appreciate the guidance and opportunity to hear and be heard on this matter as they try to use social media to the best use without exposing their record or license to unnecessary risk. Part of being in a highly regulated industry is staying ahead of the curve so that potential problems don’t become actual ones.

FINRA has provided Broker Dealers with specific guidelines regarding social media. Using these rules as a framework for RIA’s social media policies may be another helpful tool when the RIA firm is looking for a place to start the discussion on this topic.

Cosgrove Law, LLC offers consulting to RIA firms on a wide range of compliance matters.

Monday, September 19, 2011


State securities regulators' enforcement efforts were robust in 2010, according to a panel of regulators at NASAA's annual conference last week. Cosgrove Law, LLC provides both civil and criminal representation in the securities and white-collar arena, so it was interested to learn that there was a substantial increase in criminal prosecutions filed by securities regulators in 2010. For “non-fraud” cases, the regulators scored themselves a 32% increase in “failure to supervise” actions, but filed fewer “suitability” actions.

Other interesting statistics: almost half of the state regulators' enforcement actions were brought against non-registered persons in 2010. As for registered individuals, 12% of those actions were brought against investment adviser representatives (IAR's) and 23% were filed against broker-dealer agents. 5% were brought against registered solicitors, and the balance fell upon insurance industry members. The regulators continued to express ire over insurance industry members dually licensed as investment advisers with what they perceive to be an excess concentration or focus upon annuity sales.

Notably, today's Wall Street Journal has an interesting Adviser Alert that shares an important observation: investment advisers are “among regulators' best tipsters.” In our experience, reputable advisers are also likely to recommend legal counsel to new clients whom they observe to have been victimized by their prior broker or adviser or insurance agent. Food for thought.

Thursday, September 15, 2011


Members of this firm, financial industry members, and SEC and FINRA staff joined state securities and commodities regulators at their annual conference this week. As always, the conference agenda was relentless—filled with impressive panels discussing trends and developments on the broker-dealer and investment advisory side, State, Federal and SRO enforcement actions and compliance audits, as well as commodities regulation and international financial market policy. When NASAA's Enforcement Section met during the conference, its leaders listed precious metals retail sales as one of their primary concerns and enforcement priorities. The discussion, however, focused on margin sales, with an additional dose of skepticism about precious metals depository services. Notably, many interpret language in the Dood-Frank Act to preclude most transactions that combine the use of margin and storage, although the precious metals industry still awaits belated CFTC rule-making in this area.

In the interest of full disclosure, Cosgrove Law, LLC is a member of the ICTA and provides compliance services to members of the precious metals industry. Is also, however, represents investors defrauded by the less reputable members of an industry arguably vindicated by years of market appreciation. Indeed, today's Wall Street Journal published one of dozens of articles regarding the role of gold and other metals in the personal finances and portfolios of Americans struggling through another year of economic malaise and equity market volatility. To read this full article, please click here.

Friday, August 19, 2011

The Road To Financial Reform Will Be Filled With Landmines

After the passage of Dodd-Frank, industry leaders, legislators, and all levels of executive agencies have been divided into two camps: those who hail the massive bill as the answer to financial stability and those who plan and plot for its demise. Perhaps this is too harsh a dichotomy; there are likely others who remain neutral or indifferent, as well.

Regardless, because of the strong support and brazen contempt, a storm has been brewing in both camps as they lay in wait for the perfect moment to surge forward into battle. This battle will not invoke the bloody Greek combat scenes of ancient times, but may be just as epic as lawyers take to the battlefield of federal courtrooms across the country to determine the fate of Dodd-Frank.

The time for such a barrage may be upon us after the federal court of appeals decision in July struck down the Securities and Exchange Commission’s proxy access rule stemming from Dodd-Frank. The rule was implemented purportedly to make it easier for shareholders to nominate company directors. This court decision dealt a major blow to the SEC because the agency spent over 21,000 staff hours over two years drafting the rule. Since the SEC’s defeat, industry watchdogs have been examining legal challenges to other rules required by the Dodd-Frank financial oversight law.

Up until this point, Wall Street and interested industries have relied heavily on the work of lobbyists to sculpt the mandatory rulemakings by agencies like the SEC and CFTC. However, shaping the rules through lobbying may only a loophole here or there, judicial intervention could stop the rulemaking indefinitely.

In recent weeks there has been an influx of comment letters, congressional testimony, and trade group meetings, which appear to be laying the foundation to mount possible legal challenges. Apparently, one such meeting held by the U.S. Chamber of Commerce was dubbed “Dodd-Frank Excesses.” Hal S. Scott, a professor at Harvard Law School and director of the Committee on Capital Markets Regulations forecasts “lots of challenges coming down the pike.”

What Happened to the SEC Proxy Rule?

While the SEC currently weighs its options for appeal, another committee within the agency is examining the case and considering how to make adjustments to other proposed regulations in an effort to prevent future rulemaking catastrophes.

The source of the legal challenge to the proxy rule is a 1996 law requiring the SEC to promote “efficiency, competition and capital formation.” This law provided the power to enable the financial industry to build lawsuits around economic costs of rulemaking, instead of its merits. This rule was first harnessed in 2005, when the U.S. Chamber of Commerce successfully challenged SEC rules for the mutual fund industry. The Chamber has since used this provision in a succession of victories in the U.S. Court of Appeals throwing out three financial regulations over the last six years.

For now, the SEC is ramping the number of economists in its employ to ward off future attacks alleging that it did not fully evaluate economic effects of implemented rules.

Why History May Repeat Itself

Because Dodd-Frank is encompasses so many facets of the financial industry and beyond, there is no reasonable constitutional or statutory to the whole. However, arguments challenging individual sections or rules made pursuant Dodd-Frank are more feasible. The demise of the proxy rule opens up other rules to challenges.

Both the SEC and CFTC have been targets of hostile letters from financial trade groups and industry groups threatening legal action. Several of these groups are considering suits against the new SEC whistleblower program that went live last Friday. The U.S. Chamber of Commerce has argued that the whistleblower program allows tipsters to undermine internal compliance departments. Other groups have their sights set on less well-known provisions.

With industry turning up the heat, regulators have spent significant amounts of time and energy trying to shield their rules from litigation. For example, in May, the CFTC’s general counsel and chief economist issued an agency memorandum setting forth specific guidelines for cost-benefit analyses. The effect has been a slow-down of the rulemaking process and the action garnered praise that the agency has been “proactive” in taking steps to address industry concerns. Regardless of these proactive measures, it is unlikely the CFTC will come out of battle unscathed.

The Most Likely Provisions to Come Under Fire

Based on recent comment letters to the regulators and congressional testimony, Reutersreported on the five most likely targets for challenges:

Conflict Metals

First up is the conflict minerals issue. Under this rules, the SEC would require companies to make annual disclosure revealing whether they use any “conflict metals” from the Democratic Republic of Congo. Reuters states, “The proposal has become so contention that the SEC had to reopen the comment period and delay the final implementation.” The U.S. Chamber of Commerce has made comments foreshadowing a possible challenge if the SEC fails to address cost concerns. Tiffany & Company took a more direct route and argued in a recent letter to SEC that the conflict minerals rule “would violate the First Amendment.”

Speculative Position Limits

The next likely target focuses on the CFTC’s imposition of speculative position limits, which would cap the number of futures and related swaps contracts that any one speculative trader can control. The CFTC currently takes the stance that it does not need to make a finding that the limits are necessary to reduce price volatility. However in March, the Futures Industry Association (“FIA”) urged the CFTC to abandon its plan to place position limits, arguing that such limits “may be legally infirm.” In May, the FIA raised a procedural concern regarding this rule. In its letter, the FIA states that in telephone calls to CFTC staff members, they indicated an intent to add a provision in the final rule on aggregated position limits that was not included in the proposed rule. Failing to request comment on a significant change, such as aggregated position limits, could be additional grounds for a challenge.

Capital & Margin for Uncleared Swaps

So far, only the CFTC and the Federal Reserve have issued proposals outlining which traders will be required to post collateral to back up their derivatives trades. The SEC has yet to issue its proposal on this matter. Although the plans differ, they both generally impose margin on large dealers and major traders with exemptions for companies that strictly use derivative to hedge against price risk and interest-rate fluctuations. According to Reuters, the concern is that these “rules are going to impose higher costs on a wide swath of financial market players.” In its letter to the CFTC, the Coalition of Derivatives End-Users accuses that CFTC of not doing an adequate cost-benefit analysis.

Real-Time Reporting of Swap Trades

The fourth controversial issue is the CFTC and SEC’s proposals to “bolster price transparency in the swaps markets” through the use of real-time trade reporting. CFTC Commissioner Scott O’Malia has raised concerns regarding a footnote in the proposal, which admits a lack of public information regarding the proposal’s effect on market liquidity. The Chamber of Commerce, Securities Industry and Financial Markets Association (SIFMA), and several large banks have raised concerns about the costs and inflexible reporting framework of such rules.

Incentive-Based Compensation

Incentive-based compensation is the final point of concern. Both the SEC and federal banking regulators have rule proposals requiring companies to reveal their incentive-based compensation plans in addition to placing restrictions on “excessive rewards.” The potential vulnerability in these rules again lies in flaws in the economic analysis underlying the rules. The Chamber of Commerce claims the analysis, particularly the SEC’s, focuses too much on administrative burdens rather than competitive burdens.

While it is unknown what provisions will actually cause a scene in the courtroom, there is sure to be an ensuing legal skirmish. Stay tuned and watch the battle unfold.

Thursday, August 4, 2011

House Financial Services Committee Chairman Aims To Restructure SEC

On August 2, chairman of the House Financial Services Committee, Rep. Spencer Bachus, announced his intention to “modernize” the Securities and Exchange Commission. He plans to introduce the SEC Modernization Act, which will consolidate certain SEC offices and institute managerial and ethics reform.

Bachus is responding to his view that the SEC is structurally flawed, which results in operational inefficiencies. According to Bachus’ announcement, the forthcoming Act purportedly will address those issues making the agency “more efficient, consolidate duplicative offices, enable the agency to use better technology, and strengthen ethical safeguards to avoid conflicts of interest.” Despite clamoring from the SEC for additional funds, Bachus contends that additional funds will not make the agency improve performance unless these key flaws are fixed.

The draft proposal expressly amends four provisions of the Dodd-Frank Act (Sections 342, 915, 965, and 991). Such amendments would combine the Office of Compliance, Inspections and Examinations; the Division of Trading and Markets; and the Division of Investment Management. As well as consolidate the Divisions of Corporate Finance, Enforcement, Investment Management, and Trading and Markets.

According to a press release from the Financial Services Committee, the draft also makes managerial and ethics reforms, including combining the functions the Executive Director and the Chief Operating Officer, requiring the Office of Ethics Counsel to develop a system for tracking employee recusals, and restore an independent ombudsman.

John Nester, a spokesman for the SEC, responded that such changes should come internally and not imposed legislatively because internal reforms can be more readily adapted to evolving market dynamics. He also stated that the SEC is “actively reviewing a number of similar recommendations from the Boston Consulting Group study to evaluate improvements in the structure, operations, and processes of the agency.”

More detailed information regarding this draft proposal can be obtained from the House Financial Services Committee website.

Tuesday, June 28, 2011

Bailouts, Whistleblowers, and Fraud: The Whistleblowers (Part 3 of 3)

This is that final part in a three part series that will analyze the legislation that sets the foundation for the bailout and provides the means for private litigants to come forward and provide an in-depth assessment setting forth the statutory provisions, processes and procedures that whistleblowers must comply with when disclosing information regarding the misuse of TARP and other stimulus funds. We have already discussed the Federal False Claims Act, creating qui tam actions, and the Bailout Bill creating the TARP programs and subsequent fraud. This final part addresses the whistleblower protections and procedures for invoking protection, as well as the procedural requirements for filing a qui tam lawsuit.

The American Recovery and Reinvestment Act of 2009: Creating Whistleblower Protection

In early 2009, Congress enacted the American Recovery and Reinvestment Act of 2009 (“ARRA”), also known as the “Stimulus Act,” amending certain provisions in ESSA. Section 1553 of ARRA contains a broad whistleblower protection provision protecting whistleblowers who report misuse by “non-Federal employers” that received funds under ESSA or ARRA. See Pub. L. No. 111-5, 123 Stat. 115 § 1553 (2009). The purpose of including Section 1553 in ARRA was to ensure that Government funds were not mismanaged or misspent. Specifically, law prohibits non-federal employers from retaliating against an employee for reporting misuse of funds received by their non-federal employer as part of the stimulus or bailout.

The ARRA broadly defines a “non-Federal employer” as an employer that is a contractor, subcontractor, grantee, or recipient of covered funds, any professional organization, agent or licensee of the Federal government or any “person acting directly or indirectly in the interest of an employer receiving covered funds,” any State or local governments receiving “covered funds”, or any contract or subcontractor of such State or local governments. Pub L. 111-5, 123 Stat. 115 § 1553(g)(4).

“Covered funds” are also broadly defined to include "any contract, grant, or other payment received by an non-federal employer if--(A) the Federal Government provides any portion of the money or property that is provided, requested, or demanded; and (B) at lease some of the funds are appropriated or other made available by this Act." Under this definition of "covered funds," TARP funds are included, so the whistleblower protection extends to claimants making disclosure under EESA.

The definition of an “employee” is exceedingly broad to include any “individual performing services on behalf of an employer.” Pub L. 111-5, 123 Stat. 115 § 1553(g)(3). This definition therefore includes not only employees, but also independent contractors of recipient non-federal employers, thus allowing nearly anyone in an organization to become a whistleblower.

The employee disclosure must be regarding information which the employee “reasonably believes” is evidence of:

Gross mismanagement of an agency contract or grant relating to covered funds;

A gross waste of covered funds;

A substantial and specific danger to public health or safety related to the implementation or use of covered funds;

An abuse of authority related to the implementation or use of covered funds; or

a violation of law, rule, or regulation related to an agency contract or grant, awarded or issued relating to covered funds.

Protection is even extended to disclosures made in the ordinary course of the employee’s duties. Similar to other whistleblower statutes, the complainant-employee need not be correct about his belief, just that that belief be reasonable.

Obtaining Whistleblower Protection

However, in order to invoke protection under Section 1553, an employee must make the disclosure to the Recovery Accountability and Transparency Board, “an inspector general, the Comptroller General, a member of Congress, a State or Federal regulatory or law enforcement agency, a person with supervisory authority over the employee, a court or grand jury, the head of a Federal agency, or their representatives,” and then there must be some form of retaliatory action from the employer as a result of disclosure to one of these entities. Because disclosure of wrongdoing can be made to a court, a complainant would be able to seek whistleblower protection after filing an qui tam action—if the employer engaged in a retaliatory action or reprisal.

After a retaliatory action, the whistleblowing employee must submit a written complaint to the inspector general of the federal agency administering the covered funds, file a complaint online through an online complaint form or call into the Fraud, Waste, and Abuse hotline. The inspector general has 180 days to review the complaint and complete an investigation, if it decides to pursue the matter. If the inspector general cannot complete the investigation within that time period, the investigation period can be extended up to an additional 180 days, with or without the complainant’s consent. After completion of the investigation, the inspector general issues a report to his agency head. The agency then has 30 days to issue an order awarding or denying any relief, such as reinstatement, back pay, compensatory damages, benefits, attorneys fees, and costs. Ordered relief must then be taken to the District Court to be enforced. At that time, the District Court has discretion to grant additional relief including injunctive relief, compensatory and exemplary damages, attorneys fees and costs. Review of all agency orders is also available directly through appeal to the U.S. Court of Appeals.

If the agency issues an order denying relief, in whole or in part; has not issued an order within 210 days after the submission of the complaint; decides not to investigate; and there is no evidence of bad faith on the part of the complainant-employee, the complainant may bring a private action de novo against the employer for compensatory damages and any additional relief provided for in ESSA and the ARRA. Moreover, if the employee brings a private right of action, Section 1553 expressly provides a jury right in the de novo action.

In order to be successful on a claim, the whistleblower must prove that the protected disclosure was a “contributing factor” in the employer’s retaliation. Pub. L. No. 111-5. 123 Stat. 115 § 1553(c)(1)(A)(i). The ARRA specifies that in order to make this showing, the complainant must show that “the [employer] undertaking the reprisal knew of the disclosure” or that “the reprisal occurred within a time period of time after the disclosure such that a reasonable person could conclude that the disclosure was a contributing factor in the reprisal.” Id. § 1553(c)(1)(A)(ii).

There are several extraordinary measures in Section 1553, which set it apart from predecessor whistleblower statutes. First, rights under it are non-waiveable and cannot be subject to pre-dispute arbitration agreements, unlike the whistleblower provisions in the Sarbanes-Oxley Act of 2002. Further, there is no express statute of limitations for a cause of action. Arguably, however, the default 4-year limitations period will be applicable. See 28 U.S.C. § 1658(a) (providing a four-year statue of limitations for analogous causes of action). Additionally, this Section expressly states that it does not displace State laws providing additional whistleblower protection and relief, further allowing the qui tam relator to recover under both federal and state laws.

Bringing a Qui Tam Action

Remember, a qui tam relator is filing a suit on behalf of the United States. As such, a qui tam relator must follow certain procedural requirements, in addition to the ones imposed under Section 1553 of ARRA for whistleblower protection. A qui tam suit is initiated upon the filing of the complaint under seal for 60 days without service to the defendant, which means the complaint is unknown to the defendant. The purpose of this “blackout period” is to allow the Government time to (1) conduct its own investigation without the defendant’s knowledge and (2) to determine whether to intervene in the action. 31 U.S.C. § 3730(b).

Also, a copy of the complaint and a written disclosure statement is served on the U.S. Attorney and the Department of Justice. This written disclosure statement must contain “substantially all material evidence and information the person possesses.” 31 U.S.C. § 3730(b)(2). The purpose of this disclosure statement is to provide the Department of Justice with the information necessary to conduct a proper investigation that will allow it determine whether to intervene. It also provides the U.S. Attorney with the information required to determine whether it should pursue a criminal action against the defendant. The disclosure statement need not be filed simultaneously with the complaint, however it must be filed within a reasonably short period of time after. If the Department of Justice decides to intervene, it takes over the discovery and litigation process. If not, the qui tam action moves forth under the relator’s original action.


Undoubtedly, the massive amounts of Federal monies distributed under ESSA ($700 billion) and ARRA ($800 billion) coupled with the FCA and Section 1553 of ARRA will (and already have) lead to an influx of whistleblower tips and complaints. This means more federal enforcement activity, potentially subjecting bailout and stimulus recipients to civil and/or criminal liability for fraud, waste, error, and abuse.

The Emergency Economic Stabilization Act of 2008 sets forth a detailed and complex program for receiving federal monies under TARP. The False Claims Act and subsequent amending acts of Congress, such as the Fraud Enforcement and Recovery Act of 2009 and the American Recovery and Reinvestment Act of 2009, provide sources of whistleblower protection for TARP fraud qui tam relators. The interplay between these various Acts further complicates the issues surrounding TARP. Because of the complexity of these issues, it is important to select a law firm that understands the nuances of these issues and can navigate these difficult legislative provisions.

Sunday, June 26, 2011

Bailouts, Whistleblowers, and Fraud: The Bailout And The Fraud (Part 2 of 3)

This is a three part series that will analyze the legislation that sets the foundation for the bailout and provides the means for private litigants to come forward and provide an in-depth assessment setting forth the statutory provisions, processes and procedures that whistleblowers must comply with when disclosing information regarding the misuse of TARP and other stimulus funds. The second part analyzes the legislation setting up the TARP programs, the authority given to the Treasury, some of the specific requirements of imposed on TARP recipients, and finally addresses some of the most common types of TARP fraud.

Since the crash of 2008, words like “bailout” and “stimulus” have swirled around the financial and housing markets across the country. You may even be more familiar with specific programs like TARP or CAP. The bailout and stimulus programs were extraordinary acts of Congress enacted swiftly to react to the dire circumstances facing the nation at the end of 2008. But the bottom line is that the federal government pumped huge sums of money into the markets very rapidly in an effort to stabilize the marketplace. Of course in doing so, the Government opened itself up to potential fraudsters. As such, qui tam whistleblowers, acting under the Federal False Claims Act, are playing a critical role exposing fraud in the government programs created under these Bills.

The Emergency Economic Stabilization Act of 2008: Creating The Troubled Asset Relief Program

After the collapse of Bear Stearns and subsequent bank failures, Congress quickly enacted the Emergency Economic Stabilization Act of 2008 (“EESA”), more commonly known as the “Bailout Bill.” The purpose of EESA was “to immediately provide authority and facilities that the Secretary of Treasury can use to restore liquidity and stability to the financial system of the United States.” See Pub. L. No. 110-343, 122 Stat. § 3765 (2008), codified at 12 U.S.C. § 5201, et seq.

Under this authority, the Government established the $700 billion Troubled Asset Relief Program (“TARP”). Congress delegated authority under TARP to the Secretary of Treasury and the newly created Financial Stability Oversight Board. Pursuant to this authority, the Secretary of Treasury was authorized “to purchase, and make and fund commitments to purchase, troubled assets from any financial institution.” 12 U.S.C. § 5211(a)(1). It should also be noted that EESA created the $200 billion credit pool for the financial industry through the Term Asset-Backed Securities Loan Facility (“TALF”).

According to the new authority delegated to it, the Secretary of Treasury, together with several other executive agencies and departments, setup the Capital Purchase Program (“CPP”) and its successor, the Capital Assistance Program (“CAP”). Both programs operated under TARP to provide a mechanism for additional taxpayer support to stabilize the financial and banking systems whereby the Department of Treasury invested in preferred equity securities or warrants of qualified financial institutions. See GAO Report, GAO-09-161, published December 2, 2008. However, in providing relief under TARP authority, the Secretary of Treasury was required to “take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section.” 12 U.S.C. § 5211(e).

Executive Compensation & Corporate Governance Requirements

After receipt of federal funds, TARP recipients became subject to certain standards for executive compensation and corporate governance. These standards became hotly contested prompting the Treasury to promulgate “TARP Standards for Compensation and Corporate Governance.” 31 C.F.R Part 30 (2009). These new standards require recipients to:

include a provision allowing the Government to recover “any bonus, retention award, or incentive compensation paid to a senior executive officer...based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate.” 12 U.S.C. § 5221(b)(3)(B);

place “limits on compensation that excludes incentives for senior executive officers of the TARP recipient to take unnecessary and excessive risks that threaten the value of such recipients during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding.” 12 U.S.C. § 5221(b)(3)(A); and

“have in place a company-wide policy regarding excessive or luxury expenditures...which may include excessive expenditures on—(1) entertainment or events; (2) office and facility renovations; (3) aviation or other transportation services; or (4) other activities or events that are not reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the normal course of the business operations of the TARP recipient.” 12 U.S.C. § 5221(d).

In order in ensure compliance, certain senior executive officers, usually the CEO and CFO, are required to certify annually that the recipient corporation adhered to 12 U.S.C. § 5221, including submittal of an attesting statement verifying that a compensation committee or board of directors performed a semi-annual review of the TARP recipient’s luxury expenditure policy and executive compensation plan. Moreover, a recipient must also report loan volumes to the Department of Treasury on a monthly basis and prepare a quarterly report for the Office of the Comptroller of Currency describing any changes in management, use of TARP funds, and forward planning.

Most Common Types of Fraud Under TARP

The corporate governance and executive compensation standards laid out in TARP are, not surprisingly, a source of TARP fraud. Some of the most common types of fraud under TARP include the false certification of eligibility for funding; conflicts of interest for private parties managing recipient funds; collusion among participants to use Federal funds for personal financial gain; and failure to comply with these standards. Another prevalent type of fraud is known as Mortgage Modification Program Fraud, which is the falsification of residence, income and mortgage values in order to receive FHA and TARP monies. Additionally, the massive distributions of cash into the markets gave rise to money laundering illicit funds through disbursements.

EESA sets forth a detailed and complex program for received Federal funds. TARP alone encapsulates twelve different federally-funded programs to create liquidity and stability in the banking and financial markets. Navigating these complex programs is difficult and requires the skill of an experienced attorney.

Friday, June 24, 2011

Bailouts, Whistleblowers, and Fraud: The Legislation Behind Qui Tam Actions (Part 1 of 3)

Since the crash of 2008, words like “bailout” and “stimulus” have swirled around the financial and housing markets across the country. You may even be more familiar with specific programs like TARP or CAP. The bailout and stimulus programs were extraordinary acts of Congress enacted swiftly to react to the dire circumstances facing the nation at the end of 2008. But the bottom line is that the federal government pumped huge sums of money into the markets very rapidly in an effort to stabilize the marketplace. Of course in doing so, the Government opened itself up to potential fraudsters.

Special Inspector General Neil Barfosky testified to this effect before the House Ways and Means Committee on Oversight:

“We stand at the precipice of the largest infusion of Government funds over the shortest period of time in our Nation’s history. If by percentage, some of the estimates of fraud in recent government programs apply to the TARP programs, we are looking at the potential exposure of hundreds of billions of dollars in taxpayer money lost to fraud.”

As such, qui tam whistleblowers, acting under the Federal False Claims Act, are playing a critical role exposing fraud in the government programs created under these Bills.

This is a three part series that will analyze the legislation that sets the foundation for the bailout and provides the means for private litigants to come forward and provide an in-depth assessment setting forth the statutory provisions, processes and procedures that whistleblowers must comply with when disclosing information regarding the misuse of TARP and other stimulus funds. This first article looks at the legislation which created a qui tam lawsuit, the Federal False Claims Act.

The Federal False Claims Act

The False Claims Act (“FCA”), 31 U.S.C. §§ 3729-3733, was originally enacted in 1863 in response to contractors defrauding the United States Government by selling unfit supplies to both the Confederate and Union armies. It has since been revered as the single-most effective tool for detecting fraud against the U.S. Government by allowing private citizens to bring suit on behalf of the Government and share in the recovery. (Since 1986, claims brought under the FCA have recovered $28 billion).

The FCA provides that any person who knowingly submits or causes to be submitted a false or fraudulent claim to the Government for payment or approval is liable for a civil penalty of not less than $5,500 and not more than $11,000 for each such claim submitted or paid, plus three times the amount of the damages sustained by the Government. 31 U.S.C. § 3729(a); 12 C.F.R. § 85.3(a)(9).

More specifically, liability under the FCA attaches when a person:

“Knowingly presents, or causes to be presented, to an officer or employee of the United States Government or a member of the Armed Forces of the United States a false or fraudulent claim for payment or approval...” 31 U.S.C. §3729(a)(1);

“Knowingly makes, uses, or causes to be made or used, a false record or statement material to a false or fraudulent claim...” 31 U.S.C. §3729(a)(2), as amended by, The Fraud Enforcement and Recovery Act of 2009 (Pub. L. No. 111-21, §§ 4(a)(a) and 4(f)); or

“Knowingly makes, uses, or causes to be made or used, a false record or statement to conceal, avoid, or decrease an obligation to pay or transmit money or property to Government.” 31 U.S.C. § 3729(a)(7).

The terms “knowing” and “knowingly” are defined under the FCA as “a person, with respect to information—(1) has actual knowledge of the information; (2) acts in deliberate ignorance of the truth or falsity of the information; or (3) acts in reckless disregard of the truth or falsity of the information.” Moreover, the FCA does not require “proof of specific intent to defraud.” 31 U.S.C. § 3729(b).

Therefore, the FCA allows a private individual having information regarding a false or fraudulent claim against the Government to bring an action for himself, as “relator,” on behalf of the Government and to share in the Government’s recovery. The legislative intent behind sharing in the Government’s recovery was to entice private individuals to come forward with information.

However, as will be discussed in Part 3 of this series, there are certain procedural requirements with which a qui tam relator must comply. Filing a qui tam action is a complex and detailed process. It is important to choose an attorney who understands these requirements.

Friday, June 17, 2011

Second Circuit Weighs in on Scope of Broker Fiduciary Duty

On June 7, 2011, the Second Circuit rendered a decision in United States v. Allen Wolfson, Docket Nos. 10-2786-cr(L) and 10-2878-cr(CON), which weighs in on the scope of the fiduciary duty in the broker-customer context. In the case, the defendant appealed from two judgments of conviction entered on a number of different grounds, including securities fraud, relating to the defendant's involvement in a "pump and dump" stock scheme. The evidence at trial showed that the defendant artificially inflated the prices of certain thinly-traded securities in which he had amassed a substantial interest, and then unloaded those holdings on unsuspecting investors. The scheme relied on corrupt stock brokers who sold the securities for prices far above their actual value. In exchange, the defendant rewarded the brokers with exorbitant commissions. Some of the brokers failed to disclose the fact of the commissions to their customers. Others made affirmative misrepresentations about the size of these commissions.

On appeal, the defendant argued that the brokers had no duty to disclose their commissions, and that his fraud convictions, which relied on the breach of that duty to establish a scheme to defraud, must therefore be overturned. The defendant also argued that, even if a duty to disclose might arise in some contexts, the district court gave an improper fiduciary duty instruction.

The court noted that although it had long held that "there is no general fiduciary duty inherent in an ordinary broker/customer relationship," it had also recognized that "a relationship of trust and confidence does exist between a broker and a customer with respect to those matters that have been entrusted to the broker. United States v. Szur, 289 F.3d 200(2d Cir. 2002). The court noted that the fiduciary duty most commonly arises in the broker-customer relationship in situations in which a broker has discretionary authority over a customer's account. However, the court recognized that "particular factual circumstances may serve to create a fiduciary duty between a broker and his customer even in the absence of a discretionary account." United States v. Skelly, 442 F.3d 94 (2d Cir. 2006).

For example, the court noted that in Szur the owner and president of J.S. Securities had convinced brokers to market stock in exchange for unusually large commissions, sometimes as much as 50 percent of the proceeds of the sale. 289 F.3d at 212. The brokers failed to disclose the size of the commissions to their customers. The court held that, although the brokers owed no general fiduciary duty arising from discretionary authority, they were under a duty to disclose the exorbitant commissions because the information would have been relevant to a customer's decision to purchase the stock. Id. This holding was an outgrowth the court's pronouncement in SEC v. First Jersey Securities, Inc., 101 F.3d 1450, 1469 (2d Cir. 1996), where the court explained that "[s]ales of securities by broker-dealers to their customers carry with them an implied representation that the prices charged in those transactions are reasonably related to the prices charged in an open and competitive market."

In other words, the presence of a discretionary account automatically implies a general fiduciary duty, but the absence of a discretionary account does not mean that no fiduciary duty exists. For that reason, the controlling question in the case before the court was whether the jury was properly instructed on the fiduciary duty. The instructions were as follows:

Whether a fiduciary relationship exists is a matter of fact for you, the jury, to determine. At the heart of the fiduciary relationship lies reliance and de facto control and dominance. The relationship exists when confidence is reposed on one side and there is resulting superiority and influence on the other. One acts in a fiduciary capacity when the business which he or she transacts or the money or property which he or she handles is not his own or for his or her own benefit but for the benefit of another person, as to whom he or she stands in a relation implying and necessitating great confidence and trust on the one part and a high degree of good faith on the other part.

If you find that the government has shown beyond a reasonable doubt that a fiduciary relationship existed, such as between any one of the brokers and the customers you next consider whether there was a breach of the duties incumbent upon the fiduciary in the fiduciary relationship and specifically whether the defendant caused the broker or brokers to breach their fiduciary duties to customers. I instruct you that a fiduciary owes a duty of honest services to his customer, including a duty to disclose all material facts concerning the transaction entrusted to him or her. The concealment by a fiduciary of material information which he or she is under a duty to disclose to another, under circumstances where the nondisclosure can or does result in harm to the other is a [b]reach of the fiduciary duty and can be a violation of the federal securities laws, if the government has proven beyond a reasonable doubt the other elements of this offense, as I explained them to you.

The court concluded that the instruction given was identical in all material respects to the charge given in Szur, 289 F.3d at 210. Because the court found no principled basis on which to distinguish the case before it from Szur, the court concluded that there was no error in the charge.

A complete copy of the Second Circuit's decision can be found here.

Focusing Only on Dodd-Frank? Then You Might Be Missing Something

Because the Dodd-Frank financial reform bill grabs headlines every day, other regulations are entering the scene almost undetected. Broker-dealers and registered investment advisors may not be aware of new upcoming regulations, which could impact their business.

The Dodd-Frank reform bill has shaken the marketplace and the regulatory bodies. In its aftermath, there have been a flurry of mandated studies, proposals and rulemakings, but it has also spurred other agencies and organizations into action. As such, new regulations are on the horizon besides just those implemented under Dodd-Frank authority.

Last summer, in addition to passing Dodd-Frank, Congress also passed the Foreign Account Tax Compliance Act (FACTA), which imposes stricter IRS filing requirements on those having overseas assets of more $50,000 US dollars. This legislation has significant effect on institutions that hold assets for U.S. investors. FACTA will take effect in 2013.

FINRA revised its suitability rule (currently NASD Rule 2310), which is slated to go into effect on July 9, 2012. The revised rule adds five new elements that broker dealers and firms must consider: client liquidity, age, investment experience, time horizon, and risk tolerance.

FINRA also has implemented new trade-reporting requirements. In May 2011, FINRA began requiring brokerage firms to start using its Trade Reporting and Compliance Engine (TRACE) system to report trades of asset-backed securities. This coming October, broker dealers will have to begin reporting more trades and additional, previously undisclosed data into FINRA’s Order Audit Trading System.

The Department of Treasury’s Financial Crimes Enforcement Network (Fincen) has been discussing the possibility of subjecting registered investment advisory firms and hedge funds to its anti-money laundering rules. Although nothing has been implemented yet, Fincen is considering making it a requirement for these firms to file suspicious-activity reports (SARs) like banks and broker dealers.

With all of these new regulations and those yet come, it is important to have legal counsel that knows and understands the changing regulatory environment.

Wednesday, June 8, 2011

Dodd-Frank Lowers Market Manipulation Standard, Easier for CFTC to Prove

The U.S. Commodity Futures Trading Commission is on the hunt. The target: market manipulators.

On May 24, 2011 the CFTC filed its biggest market manipulation case ever in CFTC v. Parnon Energy, Inc., et al. On May 25, 2011, CFTC Commissioner, Bart Chilton, confirmed in a press conference the agency’s vow to hunt down market manipulators by stating, “We’re watching and we’ll come and get you.” As if that’s not chilling enough, Dodd-Frank provisions could make it easier for the CFTC and other regulators to bring market manipulation cases by lowering the standard of intent.

Market manipulation is a deliberate attempt to create artificial market prices or market for a particular security, commodity, or currency. In the past, in order to prove a market manipulation claim, the CFTC had to prove (1) an individual actually intended to manipulate prices; (2) that individual had the market power to move the price of a commodity; and (3) that individual actually caused an artificial price in the market. This was a difficult standard to meet--evidenced by the fact that the CFTC only has successfully prosecuted and won one market manipulation case in the futures markets over the agency’s 36-year history.

However, Dodd-Frank sets forth a new standard under which the CFTC will now have to show that a market participant acted in a manner with the potential to disrupt the market. The effect of a lower standard will be two-fold: first, it should make it easier for the CFTC to prove its case, and second, it expands the CFTC’s enforcement jurisdiction by now allowing the agency to prosecute market participants who may have merely acted in a reckless manner to cause a price in the market that otherwise would not have occurred. This standard is analogous to the current SEC standard for market manipulation in securities markets.

Additionally, Dodd-Frank leaves much discretion to the CFTC to determine its own specific enforcement rules. Although final rules have not been approved, the CFTC has stated that it will “crack-down” on three areas under the market manipulator theory: “spoofing”, “banging the close”, and high-frequency trading/algorithmic strategies. “Spoofing” occurs where a trader makes a bid or offer and cancels it before it is carried out. “Banging the close” takes place when a trader acquires a substantial position leading up to the closing period, and then offsets the position before the end of the trading day in an attempt to manipulate closing prices. Finally, the CFTC plans to investigate high-frequency trades and algorithmic strategies to determine whether such techniques have the effect of disrupting markets. If so, then these types of trades will likely face more rules and be subject to the new market manipulation standard.

Friday, June 3, 2011

FINRAs 6-Year Arbitration Eligibility Rule

In 2007, the Financial Regulatory Authority, FINRA, adopted the National Association of Securities Dealers (NASD) rule setting forth the time period in which claims can be submitted to arbitration. FINRA Arbitration Code Rule 12206(a) provides:

(a) Time Limitation on Submission of Claims

No claim shall be eligible for submission to arbitration under the Code where six years have elapsed from the occurrence or event giving rise to the claim. The panel will resolve any questions regarding the eligibility of a claim under this rule.

FINRA also provides in the introduction to the Rule:

“The Customer Code applies to claims filed on or after April 16, 2007. In addition, the list selection provisions of the Customer Code apply to previously filed claims in which a list of arbitrators must be generated after April 16, 2007; in these cases, however, the claim will continue to be governed by the remaining provisions of the old Code unless all parties agree to proceed under the new Code.”

This six-year time limitation became pivotal in In the Matter of the Arbitration Between Beja Finance International v. RBC Dain Rauscher f/k/a Tucker Anthony, Inc. In this case, the claimant, Beja Finance International (“Beja”), filed a Statement of Claim in November 2009 alleging various causes of actions when Beja provided notice of termination to RBC in the beginning of October 2000 but the termination was not complete until late-2001. Specifically, the Statement of Claim sets forth claims for negligence, breach of fiduciary duty, breach of contract, and unsuitability involving damage to Beja’s discretionary accounts with Respondent RBC after informing Respondent of its intention to terminate the use of RBC’s investment management and advisory services. Between the time of notification and completion of the termination, Beja alleged over $3 million in losses as a result of RBC’s failure to properly implement Beja’s investment objectives and a failure to reasonably execute the requested asset transfers to Julius Baer and VP Bank in 2000 and 2001.

RBC denied the allegations and sought dismissal of Beja’s claims under FINRA rule 12206(a) on the basis that the claims arose more than 6 years prior to Beja’s filing its Statement of Claim. Further, RBC argued that Rule 12206 is an eligibility provision, not a statute of limitations, so the claim cannot be revived by asserting tolling, lack of notice, or other equitable defense to “extend” the statute of limitations period. The FINRA arbitration panel agreed with RBC and dismissed Beja’s claim as being ineligible for FINRA Arbitration.

Although Rule 12206, as cited in this case, will only be effective until June 5, 2011, its successor rule retains the same “eligibility” provision insulating claims made after 6 years of occurrence regardless of claimants’ lack of notice or equitable defenses as to why their claims could not be sought earlier.

Wednesday, May 18, 2011

Federal Judge Acquits Glaxo Attorney

On May 10, 2011, Lauren Stevens, former associate general counsel for GlaxoSmithKline, was acquitted of six criminal charges surrounding allegations of obstruction and providing false answers to an FDA inquiry in violation of 18 U.S.C. 1519.

In November 2010, Stevens was indicted on four counts of making false statements, one count of obstruction of justice, and one count of falsifying and concealing documents related to GlaxoSmithKline’s off-label marketing of the anti-depressant, Wellbutrin. Last month, U.S. District Court Judge Roger Titus dismissed the charges after finding that prosecutors had given inaccurate and incomplete information to the grand jury about Stevens’ key defense--that she depended on the advice of counsel. However, the DOJ re-indicted Stevens after dismissal and the subsequent hearing ensued.

Steven’s case is noteworthy for several reasons. First, it raises concerns with in-house counsel that deal with federal government agencies, including those handling FCPA investigations or answering compliance-related questions from the DOJ, SEC, and FDA. Second, it involved an attorney safe harbor provision housed in federal statutes, which protects attorneys who rely on the advice of outside counsel. Finally, Ms. Stevens was not accused of taking part in the actual underlying wrongdoing, but was still charged in connection with the wrongdoing. This is unusual because “in most off-label drug cases, the government charges senior business executives, not attorneys” according to John Wood, former U.S. Attorney in Missouri.

Judge Titus’ ruling was equally unusual—in his tenure as a federal judge, he had never granted a directed verdict of acquittal before the defense presented its case—until now. In his opinion, Titus wrote, “I believe that it would be a miscarriage of justice to permit this case to go to the jury. There is an enormous potential for abuse in allowing prosecution of an attorney for the giving of legal advice. I conclude that the defendant in this case should never have been prosecuted and she should be permitted to resume her career.”

In coming to his decision, he stated, “it is clear that [Ms. Stevens’ statements made to the FDA] were made in good faith which would negate the requisite element [of specific intent to commit a crime] required for all six of the crimes charged in this case.” Moreover, “GlaxoSmithKline did not come to Ms. Stevens and say, assist us in committing a crime or fraud. It came to her for assistance in responding to a letter from the FDA.”

Titus said Congress designed the safe-harbor provision to protect an attorney who is zealously representing her client and “that vigorously and zealously representing a client is no a basis for charging an offense [of] obstruction of justice.” Titus concluded that Steven’s responses to the FDA “were in the course of her bona fide legal representation of a client and in good faith reliance of both external and internal lawyers for GlaxoSmithKline...[and] every decision that she made and every letter she wrote was done by a consensus.”

Accordingly, "I conclude on the basis of the record before me," Judge Titus said, "that only with a jaundiced eye and with an inference of guilt that's inconsistent with the presumption of innocence could a reasonable jury ever convict this defendant."


The SEC has provided a Wells notice regarding its intention to file civil charges, according to publicly traded life settlements company, Life Partners Holdings, Inc. Life Partners Holdings, Inc. is the parent company of Life Partners, Inc., “one of the oldest and largest life settlement companies in the United States” according to its website.

Life Partners and other life settlement companies purchase “unwanted” life insurance policies from the owners of the policies who may or may not be the insured. The purchasing company then proceeds to re-sell fractional interests in the policies to third parties. The “Life Settlement Provider” purchases the policy for an amount below the net benefit of the policy. Since the third-party purchasers of the interests, through a Life Settlement Broker, are in part responsible for the ongoing premiums on the policy, the amount of time between the purchase of the fractional interest and the death of the insured is a critical element in the investors risk/return evaluation. According to The Wall Street Journal, the Wells notice issued to Life Partners provides notice of impending charges against the company and two top executives related to these critical “life-expectancy estimates.”

Allegations of fraud related to life expectancy estimates received public attention almost a decade ago in connection with Mutual Benefits Corporation in Florida1. In that case, a doctor providing medical reports in support of life-expectancy estimates was indicted and pled guilty to securities fraud in 2007 and the company was ultimately placed under receivership. The SEC took action as well, and federal litigation followed in 2005 which was in part centered on whether or not viaticals or life settlements qualified as “investment contracts” and were therefore securities under federal securities laws.

In 2009, this law firm procured a settlement on behalf of an investor in a suit filed against a life settlement broker/investment advisor that made multiple grossly unsuitable recommendations to our client for the purchase of hundreds of thousands of dollars of life settlements. The value of the investments were based primarily upon the life-expectancy of insured persons who proved to be nearly immortal, despite promises of near-death status at the time of the viatical purchases. The Missouri Securities Division had previously taken preliminary action, albeit belatedly, against both Mutual Benefits Corporation (in 2004) and our civil defendant (investor complaint received in 2004, Cease and Desist Order issued in the fall of 2006), but both the Securities Division and the Missouri Department of Insurance failed to garner a remedy for the investors or take action against the investment advisors and broker-dealers that failed to supervise the representative/life settlement broker/insurance salesman. In sum, it seems the more things change, the more they stay the same!

1The State of Florida also filed a criminal charge in 2001.

Tuesday, May 17, 2011

Study Finds It Might Be Better to Fight the SEC & FINRA Than Settle

A study conducted by financial services law firm Sutherland Asbill & Brennan finds that it sometimes pays for broker-dealers and registered representatives to take on regulators. The study analyzes the outcomes of disciplinary and administrative proceedings between October 2008 and September 2010—the SEC’s 2009 and 2010 fiscal years.

Some key findings:

57% of the time, the SEC fails to prove fraud charges, but FINRA had a 100% success rate (4 of 4 fraud charges were proven).

33% of SEC respondents were successful in receiving reduced sanctions when cases were appealed from SEC Administrative Law Judge (ALJ) to the full Commission

33% of the time the ALJ or the Hearing Panel imposed lower monetary sanctions than the amount FINRA or SEC staff initially sought, but 33% of the time the ALJ or Hearing Panel imposed higher monetary sanctions.

28% of SEC respondents got charges dismissed compared with 8.6% of FINRA respondents (out of 237 litigated charges)

FINRA respondents represented by counsel were significantly more successful than pro se respondents. Since 2006, only one pro se FINRA respondent successfully got charges dismissed.

Often firms and individuals think it is better to settle with the regulators. However, based on the findings of this study, in some circumstances—usually where fraud is charged, respondents will fare better if they come before a judge or hearing panel. Further, the study purports to establish that there might not actually be a “settlement discount,” which is a tactic used by the regulators to incentivize settlement before entering into litigation. However, the study admits that the sample used to determine this finding is not likely a representative sample.

The bottom line: seek legal counsel before making the decision to settle or litigate. Again, the study only finds that litigants are more successful some of the time over those who settle.

Monday, May 16, 2011

FINRA's Ketchum Testifies Before Subcommittee on Oversight and Investigations

On May 13, 2011, Richard Ketchum, Chairman and CEO of FINRA, testified before the House Subcommittee on Oversight and Investigations. Ketchum's testimony related to the changes made at FINRA as a result of the Special Review Committee, established in 2009 by the Board of Governors, which conducted a review of FINRA's examination program as it related to the detection of fraud and Ponzi schemes. Specifically, he focused on the Special Committee's findings relating to the Ponzi scheme perpetrated by R. Allen Stanford. Stanford was behind the orchestration of a fraudulent, multi-billion dollar investment scheme centering on an $8 billion CD program.

Ketchum testified that between 2003 and 2005, the National Association of Securities Dealers—FINRA's predecessor entity—received information from at least five sources claiming that the Stanford CDs were a potential fraud. Despite the existence of these red flags, FINRA did not launch an investigation of whether the Stanford CD program was a fraud until January 2008.

Ketchum testified that FINRA missed a number of opportunities to uncover the Stanford firm's role in the CD scheme. First, FINRA's Dallas office cut off an investigation because they were unsure of the full scope of FINRA's investigative authority and because they believed that the offshore CDs upon which the Ponzi scheme were based were not "securities" regulated under federal securities laws.

Second, FINRA procedures at the time did not set forth criteria for escalation of a matter to senior management or the use of specially trained investigators based on the gravity and substance of the fraud allegations.

Third, FINRA's Dallas staff did not adequately document communications with the SEC, or discussions within FINRA itself, regarding the CD program.

Finally, FINRA at the time did not have a centralized database that gave examiners direct, electronic access to all relevant complaints and referrals associated with a firm. Consequently, no individual FINRA staff member was ever aware of all of the "red flags" related to the Stanford firm.

Following the investigation, the Special Committee made recommendations which sought to remedy the weaknesses revealed at FINRA. Among the recommendations were the following strategic objectives:

(i) greater emphasis should be placed on the detection of fraud;
(ii) potential fraud situations and other situations presenting serious potential risk to investors should be escalated promptly and properly;
(iii) examination staff should be diligent in pursuing potentially serious issues, exercising an appropriate degree of skepticism;
(iv) all FINRA operating units should closely coordinate and communicate in carrying out the examination program; and
(v) FINRA should provide additional resources to strengthen its cause examination program.

As a result of these recommendations made by the Special Committee, Ketchum stated that FINRA made the following changes:
  • FINRA created the Office of Fraud Detection and Market Intelligence in October 2009. This group houses the Central Review Group, Office of the Whistleblower and the Insider Trading and Fraud Surveillance teams, and is responsible for the centralized intake and triage of regulatory filings and investor complaints.
  • FINRA enhanced its examination programs and procedures in a variety of ways intended to help FINRA better detect conduct that could be indicative of fraud. Some of the enhancements FINRA has made to its examination program are: 1) focusing resources on highest-priority matters; 2) enhanced expertise of regulatory staff; 3) enhanced use of third-party and other information; and 4) multi-year technology enhancement plan.
  • FINRA has increased communication and coordination with the SEC relative to our respective programs. FINRA and SEC staffs meet routinely to share details about strategic design and tactical delivery of information to the respective regulatory programs of each organization.
  • In late 2010 FINRA created a new Office of Risk to begin the process of strengthening its ability to identify high-risk firms, branch offices, brokers, activities and products through broader data collection and more comprehensive analysis.
Ketchum concluded by stating that these steps will cause FINRA to become a more effective regulator, especially in terms of enhancing its ability to quickly identify and investigate conduct that could indicate fraud or other serious customer harm. A complete copy of Ketchum's statements can be found here. The SEC's litigation release with regard to the Stanford Ponzi scheme can be found here.

Client’s Ponzi Scheme Gets Law Firm and Attorney Sued

A bankruptcy trustee filed suit April 28th against Estate Financial Inc.’s (EFI) former attorney and her employing firm, Bryan Cave LLP, alleging that their legal advice led to more than $100 million in losses from over 1,500 investors.

The complaint claims that Bryan Cave LLP, an international law firm with lawyers in St. Louis, and one of its attorneys from its Los Angeles office, Katherine Windler, failed to advise EFI to conform to various California and federal laws.

The suit, filed in the central district of California, alleges that Windler and Bryan Cave were retained to conduct a compliance review and audit of EFI’s business practices. The compliance review revealed that EFI was in violation of “countless real estate, securities and corporate laws, rules and regulations.” According to the complaint, regardless of this knowledge, Windler “counseled EFI to continue its current business activities,” which allegedly allowed EFI principals Karen Guth and Josh Yaguda to steal over $100 million from investors through a ponzi scheme. The scheme involved selling membership interests in a fund held by EFI, the Estate Financial Mortgage Fund, LLC, under restricted or expired permits. The complaint cites to various documents and email communications between Windler and EFI’s principals evidencing her purported knowledge of the fraud.

In 2009, Guth and Yaguda pleaded guilty to 26 felony counts of fraud. Guth is serving 12 years in prison and Yaguda 8 years.

This lawsuit serves as a tragic reminder to attorneys that performing in accordance with the rules of professional responsibility should always be at the forefront of any client matter. It also provides a chilling warning to corporations about the need for reputable and honest compliance counseling.

Wednesday, May 11, 2011

Man Convicted of Eleven Counts of Fraud in Connection with Business Opportunity Scheme

Yesterday, May 10, 2011, a federal jury in Miami convicted Sirtaj Mathauda of nine counts of mail fraud, two counts of wire fraud, and conspiracy related to a fraudulent business opportunity scheme according to a Department of Justice Press Release.

The complaint charged Mathauda and his co-conspirators of operating bogus companies known as Apex Management Group, USA Beverages Inc., Omega Business Systems and Nation West Distribution. According to the complaint, “the companies operated largely out of phone rooms in Costa Rica and marketed to residents in the United States.”

The companies sold “business opportunities” to own and operate vending machine routes, beverage distributorships, and greeting card distributorships. These opportunities were sold as a complete package, including retail display racks or vending machines, access to high-traffic locations, and assistance in maintaining and operating such businesses. However, the promises of good locations and business assistance were fabricated.

Based on evidence presented at trial, salesmen in the phone rooms told potential customers that the companies were located in the United States and would provide profitable distribution routes for either the vending machines or retail display racks. Further, salesmen asserted that the companies had a track record of success. This so-called “record of success” was backed by phony references pretending to be satisfied customers of the companies.

Mathauda owned, managed or worked at the fraudulent companies in Costa Rica between 2004 and early 2009. Several of his co-conspirators Dilraj “Rosh” Mathauda, Stephen Schultz, Silvio Carrano, Donald Williams, Patrick Williams and Gregory Fleming, previously pled guilty in Miami in connection with their roles in these fraudulent business opportunity scams.

All of the defendants were charged as part of the government’s continued nationwide crackdown on business opportunity fraud. A stance supported by Tony West, Assistant Attorney General for the Justice Department’s Civil Division who stated that “The Department of Justice will continue to prosecute aggressively those who are exploiting consumers to make a quick buck for themselves.” The DOJ is honing in on business opportunity fraud because it “imposes major financial hardship on innocent, hardworking victims” especially now during tough economic times.