Tag Archives: corporate investigations

Whistleblower Rejects $8.25 Million SEC Award

On August 19, 2016, Eric Ben-Artzi, a former Deutsche Bank risk officer, stated he would not accept his portion of a $16.5 million whistleblower award from the SEC because the executives he contends were responsible for overvaluing certain portfolios at the bank were not being personally held accountable in the bank’s settlement with the SEC.  Ben-Artzi had provided information to the SEC, which led to a $55 million fine and settlement in 2015.

Ben-Artzi’s main criticism of the settlement and whistleblower award is that Deutsche Bank shareholders and rank-and-file employees bear the cost of paying such penalties.  He also accused the SEC of having too many connections to the bank through the “revolving door” between government and the industry.  Ben-Artzi noted that his ex-wife and attorneys may have claims on portions of the award.  He also stated that he would accept his portion if he was sure it came out of the pockets of the executives who he claims caused violations of the securities laws.

Here’s a Bloomberg article on the subject:

http://www.bloomberg.com/news/articles/2016-08-19/deutsche-bank-whistle-blower-spurns-8-million-reward-from-sec

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Auditing the Auditor: SEC Charges Firm With Inadequate Surprise Exams

On April 29, 2016, the SEC brought and settled charges that an accounting firm, Santos, Postal & Co. (“Santos”) and one of its principals, Joseph Scolaro (“Scolaro”), performed inadequate surprise exams of one of their investment advisor clients, SFX Financial (“SFX”), the president of which stole over $670k from SPX clients. Santos and Scolaro neither admitted nor denied the allegations in the SEC Order but consented to its entry and to disgorgement and penalties totaling over $55,000. Santos and SColaro agreed to be suspended from practicing before the SEC, which includes preparing financial reports and audits of public companies. Santos and Scolaro are permitted to apply for reinstatement after one and five years, respectively.

Because SFX was deemed to have custody of client assets under SEC Rule 206(4)-2 (the “Custody Rule”), SFX was required to hire an independent accountant (Santos) to perform surprise audits. The Custody Rule seeks to protect clients from asset misappropriation by investment advisors (e.g., Ponzi schemes). Accordingly, among other things, Santos was supposed to contact SFX’s clients to verify that they were aware of the contributions and withdrawals into and out of their accounts as reflected in SPX’s records. According to the SEC Order, Santos failed to actually contact clients about such transactions.

The SEC previously announced charges against SFX’s president Brian Ourand, who was later found by an administrative judge to have misappropriated funds from client accounts in violation of the Investment Advisers Act of 1940. Ourand was ordered to pay disgorgement of $671,367 plus prejudgment interest and a $300,000 penalty, and was barred from the industry. SFX and its CCO separately agreed to settlements.

The SEC’s Order relating to Santos and Scolaro can be found here:

https://www.sec.gov/litigation/admin/2016/34-77745.pdf

Investment Advisors Beware: Ten Things OCIE Is Looking At

The SEC is increasing the number RIA inspections by the Office of Compliance Inspections and Examinations (OCIE) and has signaled an aggressive agenda for such exams. Here is a non-exhaustive list of items a Chief Compliance Officer and his or her staff may want to consider well in advance of getting a call from OCIE:

  1. Cybersecurity Policies and Procedures: Make sure the firm’s policies are periodically reviewed and cover key issues (e.g., electronic security (passwords, encryption, “need to know” segmentation), physical security, employee training, incident response planning, and vendor due diligence).
  2. Product Selection: For both RIAs and BDs, the SEC is taking a close look at certain products (e.g., variable annuities) sold to retail investors. Ensure proper monitoring of client recommendations and allocations.
  3. Performance Advertising: Pay particular attention to the distinctions between true actual performance, model performance, and back-tested performance.
  4. Third-Party Affiliations: Disclose any business relationships with 3d parties (e.g., solicitor and sub-advisory relationships) and the potential conflicts they pose.
  5. Fee Structure/Reverse Churning: OCIE is looking at disclosures re: fee structure and the appropriateness of fee-based compensation (e.g., is a firm actively managing an account or just collecting fees).
  6. Custody: “Custody” is broadly defined in Rule 206(4)-2. Firms that have custody need to comply with the Rule’s requirements (e.g., hire an independent CPA to conduct an annual surprise audit).
  7. Code of Ethics/Insider Trading: Make sure the Code is up to date and has adequate personal trading and disclosure restrictions.
  8. Best Execution: If firm has authority to pick BDs, make sure to disclose how firm selects BDs and any “soft dollar” arrangements.
  9. Principal Trading: Disclose it; make sure Rule 3T being followed.
  10. Anti-Money Laundering Policies: For firms that are also BDs, make sure to have AML policies and procedures designed to pick up on suspicious activity (e.g., lots of relatively small transactions).

SEC Laser-Focused on Conflicts Disclosures by Advisors and Broker-Dealers

In two recent cases, the SEC ordered JP Morgan Chase to pay over $270 million for what it deemed inadequate disclosures about certain conflicts of interest. When closely examined, these two cases illustrate just how detailed and granular the Commission can be when evaluating and prosecuting conflicts non-disclosure issues.

The Proprietary Funds Case

On December 18, 2015, the SEC announced that two J.P. Morgan wealth management subsidiaries had admitted wrongdoing (though no intentional violations) relating to the firm’s investment advisory business and agreed to pay $267 million.[1] Specifically, J.P. Morgan Securities LLC (JPMS) and JPMorgan Chase Bank, N.A. (JPMCB), preferred to invest clients in the firm’s proprietary mutual funds without properly disclosing this preference to clients. In addition, JPMS breached its fiduciary duty to certain wealthy clients when it did not inform them that they were being invested in a more expensive class of J.P. Morgan mutual funds shares than other available classes, or that JPMS preferred third-party-managed hedge funds that made certain “retrocession” payments to a J.P. Morgan affiliate.

The level of scrutiny applied in this case is striking. The SEC was initially focused on a possible charge that JPMS was improperly steering clients to house products so that it and its affiliates could make additional fees. JPMS’s Form ADVs, however, disclosed that JPMS “may have a conflict of interest in including affiliated [Mutual] Funds…because [JPMS] and/or its affiliates will receive additional compensation.” Further, in advance of opening an account, JPMS clients were specifically informed how much of their assets were to be allocated between proprietary mutual funds and third-party funds. Because of such disclosures, the SEC pivoted to the theory that there should have been an additional disclosure that JPMS “preferred” to invest client assets in proprietary products.

Holding the bank to this level of scrutiny seems severe; as noted, JPMS disclosed its incentive to put client money into house funds and these were discretionary accounts. Its “preference” for house funds seems axiomatic. All things considered, however, the penalty could have been far worse. Perhaps because of its cooperation and proactive remedial measures, J.P. Morgan was permitted to continue to provide these kinds of investment advisory services and was able to avoid the so-called automatic “bad actor” disqualification, which would have blocked it from the lucrative business of raising money for private companies, including hedge funds and startups. In addition, while the penalties and disgorgement are certainly significant, they amount to roughly one month of JPMS’s operating profits.

The Broker Compensation Case

In the second settlement, JPMS agreed to pay $4 million to resolve charges that it falsely stated on its private banking website and in marketing materials that individual advisors were compensated based on the performance of client investments, not on commission.[2] As it turned out, advisor compensation was not tied to investment performance; it consisted of a salary plus a bonus determined by a number of factors, none of which were performance based. Although it appears that no investor was harmed, the SEC believed that sanctions were warranted: “JPMS misled customers into believing their brokers had skin in the game and were being compensated based upon the success of customer portfolios.”[3]

Bottom Line

Based upon recent developments, it is clear that the SEC intends to look under every rock to see if all conflicts of interest, regardless of their severity, have been disclosed. Accordingly, firms should take a close look at their business practices and make sure their Form ADVs, websites, marketing materials and other disclosure documents accurately reflect those business practices.

[1] http://www.sec.gov/litigation/admin/2015/33-9992.pdf. The $267 million consisted of penalties, disgorgement and interest.

[2] https://www.sec.gov/litigation/admin/2016/33-10001.pdf. JPMS neither admitted nor denied any wrongdoing.

[3] https://www.sec.gov/news/pressrelease/2016-1.html.

SEC Awards Whistleblower-Executive A Half-Million Dollars For “Reporting Out.”

The SEC has doled out over $50 million in awards to 15 individuals since it inaugurated the Dodd-Frank mandated whistleblower program 3 years ago. That program permits whistleblower awards of 10% to 30% of the total money recovered from a securities law violator provided the sanctions exceed $1 million. Whistleblower awards are usually restricted to individuals who provide original information derived from their independent knowledge or analyses. Failure to be deemed an “original” source of information is ordinarily the end of a whistleblower claim.

On March 2, 2015, however, the SEC approved an award of $475,000 to $575,000 to an unnamed executive who merely passed along original information.[1] That award stemmed from a special carve-out designed to incentivize officers and directors to report out where the company fails to take corrective action. Specifically, an executive may be entitled to a whistleblower award if he or she reports information to the SEC 120 days after alerting upper management of the problem. Similarly, if upper management is already aware of the problem at the time the executive learns of it, the executive-whistleblower must wait 120 days before reporting to the SEC.

The rationale for the 120-day rule is two-fold. On the one hand, the SEC wants to protect companies that have robust compliance programs in place and a strong compliance tone from the top. After all, companies who invest in compliance programs and take potential violations seriously should be afforded a safe harbor whereby they are protected from individuals hoping to make a quick buck by passing information along before the 120-day period expires.

On the other hand, the SEC realizes that executives and directors are uniquely placed to take action when upper management will not remedy the problem. Executives regularly receive management and compliance reports and are often the first persons to whom an employee will turn to report an issue. The SEC wants to incentivize such executives to step forward when upper management refuses to take corrective action.

However, an executive considering becoming a whistleblower risks significant reputational and financial harm. Although the whistleblower process is anonymous, upper management at the company may be able to figure out who reported out and may take retaliatory action against that individual.   Or, the individual may have already resigned due to irreconcilable differences with the company. In either case, there is no guarantee of a whistleblower award. Accordingly, executives and directors thinking about “reporting out” should carefully consider the quality of the information they possess and the potential financial and reputational risks.

[1] https://www.sec.gov/news/pressrelease/2015-45.html#.VP79EIHF87M

Fifth Time’s A Charm – A Series Of Corporate Disclosures, Together, Can Be A “Corrective Disclosure.”

On October 2, 2014, a federal appeals court revived an investor class action that had been dismissed by the trial court for failure to plead loss causation. The case is Public Employees Ret. Sys. of Mississippi v. Amedisys, Inc., 13-30580 (5th Cir. Oct. 2, 2014).[1] In it, the Court found that a series of partial disclosures could collectively constitute a “corrective disclosure” of the defendant’s misrepresentations, which the plaintiffs plausibly alleged caused a decline in the defendant’s stock price.

The plaintiffs filed a complaint against Amedisys, a home health care services provider, and certain executives alleging that the company issued false and misleading public statements that concealed its fraudulent Medicare billing practices and artificially inflated its stock price between 2005 to 2010. The complaint alleged that a series of five “partial disclosures,” spread over two years, revealed the misrepresentations and caused a decline in the stock price, as the truth became known.

The disclosures, which spanned from August 2008 to September 2010, included two news reports questioning Amedisys’s billing practices; a press release announcing the resignation of its CEO and CIO; announcements of investigations into the company by the Senate Finance Committee, the SEC, and the DOJ; and the announcement of disappointing operating results in the second quarter of 2010. During the same time period, Amedisys’s stock price gradually declined from $66.07 to $24.02, a drop of over 60%.

The district court analyzed each of the disclosures separately and found that none of them constituted a “corrective disclosure,” which exposed the falsity of Amedisys’s prior statements. The district court dismissed the complaint with prejudice for failure to adequately plead that the plaintiffs’ losses were caused by the company’s misrepresentations.

The Fifth Circuit, however, found that a corrective disclosure does not have to be a single disclosure and analyzed the five disclosures in the Complaint “collectively.” The Court admitted that, if taken alone, the individual disclosures did not make the existence of fraud more probable, noting that neither media speculation concerning wrongdoing nor the mere commencement of a government investigation constitute a corrective disclosure of fraud. Nevertheless, the Court ruled that when taken together, the entire series of events plausibly indicated that the market “was once unaware of Amedisys’s alleged Medicare fraud, had become aware of the fraud and incorporated that information into the price of Amedisys’s stock.” Importantly, the Court noted that the Complaint linked each of the partial disclosures to a corresponding drop in stock value. Accordingly, the Court held that the plaintiffs adequately pled that Amedisys’s alleged false statements caused their loss and reversed the district court’s dismissal.

[1] http://www.ca5.uscourts.gov/opinions%5Cpub%5C13/13-30580-CV0.pdf