Quarterly Securities Enforcement Briefing
- 1st Circuit Hands SEC Major Reversal While SEC Doubles Down on In-House Courts
- The U.S. Supreme Court to Review Salman Insider Trading Case as SEC Weighs In
- SEC Whistleblower Tips and Claims Surge Again in 2015
1st Circuit Hands SEC Major Reversal While SEC Doubles Down on In-House Courts
By Candice M. Tewell
As we reported last year, the SEC has substantially increased its use of in-house administrative proceedings before SEC-employed Administrative Law Judges (“ALJs”). Appeals from the ALJs’ decisions are then reviewed by the SEC’s own commissioners. But the SEC cannot entirely remove itself from the jurisdiction of the federal courts—and the 1st Circuit recently handed the SEC a significant reversal, reminding the SEC it has to play by the rules, even in its own in-house courts.
In Flannery v. SEC, Nos. 15-1080, 15-1117 (1st Cir. Dec. 8, 2015), the 1st Circuit reversed the SEC’s order imposing sanctions against James Hopkins and John Flannery of State Street Global Advisors (“State Street”) for securities violations during the 2007 subprime mortgage crisis. The 1st Circuit’s decision explores the limits of court deference to Commission decisions, gives teeth to the “substantial evidence” standard of review, and provides a useful roadmap for evaluating and defending allegations of material misstatements in securities cases.
In 2010, the SEC instituted proceedings against Hopkins (a former State Street vice president) and Flannery (a former chief investment officer) based on allegedly misleading communications to investors in a State Street-managed fund. Following an 11-day hearing, involving testimony from 19 witnesses, the ALJ issued a 58-page decision finding neither Hopkins nor Flannery made any false or misleading statements. The decision was a rare defeat for the SEC in its in-house courts (in which it has a 90% success rate).
The SEC’s Division of Enforcement appealed the ALJ’s decision to the five-member Commission. Three years later, the commissioners issued a 3-2 decision reversing the ALJ. As to Hopkins, the Commission determined that a single slide in a presentation he had given to a group of investors was materially misleading regarding the percent of the fund invested in asset-backed securities. As to Flannery, the Commission found he was liable to misstatements in two letters. Both men were suspended for one year from association with any investment adviser or company and assessed a civil monetary penalty.
Hopkins and Flannery appealed to the 1st Circuit, which reversed. The Court found the SEC’s showing of materiality related to the single slide in Hopkins’ presentation was “marginal” and the SEC failed to demonstrate he acted with scienter. As to Flannery, the Court concluded one of the two letters cited by the Commission was not misleading, and even assuming the other letter might have been, the single alleged misstatement was not sufficient to hold Flannery liable under the relevant law (which required a course of dealing).
Two aspects of the Court’s decision were of particular interest to observers of the SEC’s increased use of in-house courts. First, the Court’s stringent review gave the Commission less deference than we have come to expect of a “substantial evidence” standard of review. The Court rejected a number of key factual findings by the Commission and explained how the Commission “misread” one of the communications at issue. Second, the Court focused on context when evaluating materiality and scienter. Although the Court acknowledged a single misleading statement could be actionable under certain securities laws, it reminded the SEC that materiality and scienter must be considered in the context of the presentation or statement at issue and the other information readily available to investors.
While this loss gives hope to individuals and companies facing the SEC’s in-house courts, we will have to wait and see if other courts follow the 1st Circuit and engage in a searching inquiry of decisions coming out of the SEC. Meanwhile, the SEC continues to bring civil enforcement actions in its in-house courts despite the continuing constitutional challenges the system faces. The 4th Circuit recently refused to block the SEC’s administrative action pending an appeal challenging the constitutionality of the process. See Bennett v. SEC, No. 15-2584 (4th Cir. Jan. 22, 2016). The 4th Circuit may be foreshadowing that it will join the 7th and D.C. Circuits in refusing to consider challenges to the SEC in-house court’s constitutionality while an administrative claim is underway. In contrast, the 2nd Circuit in September froze a contested administrative proceeding so that it could consider the issues surrounding the SEC’s in-house court. A district court judge in Georgia has likewise stayed several SEC administrative proceedings, finding that the agency’s in-house court is likely unconstitutional. See Ironridge Global IV v. SEC, No. 15-cv-2512 (N.D. Ga. Nov. 17, 2015); Gray Fin. Grp. Inc. v. SEC, No. 15-cv-492 (N.D. Ga. Aug. 4, 2015); Hill v. SEC, 15-cv-1801 (N.D. Ga. June 8, 2015). The SEC has appealed the judge’s rulings to the 11th Circuit.
The U.S. Supreme Court to Review Salman Insider Trading Case as SEC Weighs In
By Conner G. Peretti
On Jan. 19, 2016, the U.S. Supreme Court agreed to review an Illinois man’s appeal of his insider trading conviction in U.S. v. Salman, which the 9th Circuit affirmed in July. The Supreme Court’s decision to review Salman is the latest chapter in the courts’ re-examination of insider trading law in the tipper-tippee context, particularly as to what constitutes a sufficient “personal benefit” to the tipper to establish liability for the tippee. On Dec. 20, 2014, the 2nd Circuit issued its landmark U.S. v. Newman decision, dismissing indictments against two individual “tippees” convicted of insider trading because the government failed to prove that they knew that the insiders who tipped them the information received a “personal benefit” in the form of a pecuniary interest or other thing of value for the tips.
Later, in Salman, the 9th Circuit disagreed with Newman, asserting that an earlier Supreme Court case, Dirks v. SEC, previously held that “personal benefit” included “[p]roof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend.” That is, the 9th Circuit believed that Dirks required the meaning of “personal benefit” to include the intangible benefit to the tipper of giving a gift of information to a friend or relative. Interestingly, Judge Rakoff sat by designation on the 9th Circuit panel that decided Salman. As a judge for the District Court for the Southern District of New York, he would typically be bound by decisions of the 2nd Circuit, such as Newman. Salman created the Circuit split that likely motivated the Supreme Court to take up the Salman appeal and clarify insider trading law in the tipper-tippee context.
On Dec. 11, 2015, the SEC agreed to hear an appeal of an in-house judge’s decision dismissing charges against a former Wells Fargo employee for insider trading. The administrative case and appeal mirrors Newman and the Supreme Court’s review of Salman. The Commission stated, “This appeal raises issues as to which we have an interest in articulating our views and important matters of public interest, including insider trading law and the personal benefit requirement.” The original decision, issued in September 2015, dismissed the case for failure to show the tipper received any personal benefit in exchange for providing the information. SEC enforcement division attorneys argued that the in-house judge read Newman too narrowly, and the appeal followed. This case runs parallel to Salman and Newman, which may affect the outcome of the SEC case. The SEC is likely to file a brief with the Supreme Court in Salman to provide its views.
SEC Whistleblower Tips and Claims Surge Again in 2015
By John A. Goldmark
The SEC issued the 2015 Annual Report on its Whistleblower Program, announcing that whistleblower tips to the Commission grew significantly again this last year. According to the report, the SEC received 3,923 tips during the 2015 fiscal year, which is more than an 8 percent increase over the prior year. The SEC also experienced a surge in the number of whistleblower claims seeking payout after successful enforcement actions, so-called “bounty claims.”
Under the Dodd-Frank Act of 2010, the SEC is required to pay whistleblowers who provide information to the SEC that results in a successful enforcement action of more than $1 million in sanctions. The SEC has discretion to pay between 10 and 30 percent of the sanctions it collects, depending on the facts of the case. Factors that increase the size of the award include the significance of the information provided and the level of whistleblower assistance, while factors decreasing the award include the whistleblower’s involvement in the underlying conduct or delay in providing the tip. The SEC attributes the continued rise in whistleblower awards to increased public awareness of the whistleblower program and the significant funds it has paid out under the program, which now total more than $52 million.
One notable trend from the 2015 SEC report is that 80 percent of the whistleblower award recipients first raised their concerns internally before going to the SEC. This emphasizes that it is important for companies to have appropriate procedures for handling whistleblower tips (meritorious or not) when they arise, including by engaging counsel as early as possible to investigate and advise on the proper path forward.