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.

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.

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.

Conclusion

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.

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.

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.

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.