July 13, 2016
In the wake of a record-breaking 2015, the SEC’s Division of Enforcement appeared to continue to initiate new matters at breakneck speed throughout the first half of 2016. The agency appeared particularly active in the public company reporting space. As described in prior publications, the slowdown in public company financial reporting and disclosure cases over the past decade has reversed course. In fiscal 2015, these matters comprised the largest portion of the Division of Enforcement’s docket, and that pace looks to have continued through the past six months. That said, most of the cases continued to involve smaller companies, and the cases involving auditors in particular were not of the same blockbuster nature as several 2015 matters.
Similarly, while cases involving investment advisers, broker-dealers, and financial institutions remained a mainstay of the Enforcement docket, there appeared to be fewer cases raising significant emerging issues of concern for the industry, although scrutiny of brokers in connection with complex trading platforms and protection of customer privacy led to some noteworthy matters. One area in which the agency was busier than last year is in the municipal securities and pension arena; though still a relatively small segment of the Enforcement universe, there were a number of interesting cases in recent months.
Meanwhile, looking forward, the Division of Enforcement has indicated several priorities likely to shape its future docket, including its scrutiny of private equity advisers (particularly in regards to undisclosed or misallocated fees and expenses and inadequately disclosed conflicts of interest) and various issues involving high-profile pre-IPO companies (including crowdfunding and secondary market trading).
Our report begins with a general assessment of interesting developments from the past six months, including several important court rulings and a review of whistleblower activity. We then review cases of note from each of the Division of Enforcement’s major program areas.
One of the more important court rulings for those who litigate against the SEC came out of the Eleventh Circuit, which broke from several other courts in ruling that SEC claims for disgorgement and declaratory relief are subject to the five year statute of limitations set forth in 28 U.S.C. § 2462. While claims for penalties and other punitive remedies are typically barred by the statute of limitations, the courts have generally held that forward-looking remedies are not subject to the statute. However, disagreeing with rulings from the DC and Ninth Circuits, the Eleventh Circuit held in SEC v. Graham that the SEC’s request for disgorgement was time-barred.
In Graham, the SEC brought a civil enforcement action in the Southern District of Florida, alleging that the defendants had sold unregistered securities from at least November 2004 to July 2008. The district court dismissed the case, finding that all of the remedies sought by the SEC were barred by 28 U.S.C. § 2462, which prohibits any action “for the enforcement of any fine, penalty, or forfeiture” if brought more than five years from the date the claim first accrued.
On appeal, the Eleventh Circuit rejected the district court’s decision in part, holding that Section 2462 does not apply to injunctions because they are typically forward-looking with the purpose of preventing future violations. However, the Court affirmed as to the SEC’s demand for declaratory relief and disgorgement, holding that declaratory relief constitutes a “penalty” under the statute because it is backward-looking and intended to punish past wrongdoing, and that disgorgement is effectively synonymous with the ordinary meaning of “forfeiture” under the statute. The Graham decision sets up a circuit split which may ultimately need to be resolved by the Supreme Court.
Second, in a ruling that will be useful to parties under SEC investigation who are faced with parallel private litigation, a federal district court denied a plaintiffs’ firm’s request for access to the SEC’s investigative files under the Freedom of Information Act (“FOIA”). In an action stemming from an SEC investigation into alleged violations of the Foreign Corrupt Practices Act (“FCPA”), the SEC prevailed in dismissing a lawsuit brought by Robbins Geller Rudman & Dowd, which had filed a FOIA request seeking documents that the SEC obtained in the course of its ongoing investigation. In refusing to turn over these documents, the SEC relied on Exemption 7(A) of FOIA, which provides that the government may withhold documents and information that are “compiled for law enforcement purposes,” the disclosure of which “could reasonably be expected to interfere with enforcement proceedings.”
Ruling on the SEC’s motion to dismiss, the United States District Court for the Middle District of Tennessee held that the SEC properly withheld the documents it received from the company under Exemption 7(A). The court agreed with the SEC that disclosing these documents would reveal the nature and scope of the agency’s investigation. The court also rejected the argument that the SEC was required to disclose those documents that were already made public through a 2012 press report and a related Congressional investigation, emphasizing that the SEC’s investigative interests differed from those of journalists or legislators.
Finally, in another decision highlighting the interplay between SEC investigations and private securities litigation, Judge John Koeltl of the Southern District of New York dismissed a putative securities fraud class action against Lions Gate Entertainment Corp., finding that the company did not have an independent duty to disclose to investors that the company had received a Wells notice, that it was under investigation by the SEC, and that it intended to settle with the SEC. Judge Koeltl held that these enforcement-related developments were not per se material to investors and their nondisclosure did not, as the putative class alleged, constitute a violation of Section 10(b) of the Securities Exchange Act of 1934.
The SEC notched a few more examples of its growing use of cooperation agreements. Notably, the SEC also recently made a pointed illustration of the consequences for those who renege on their cooperation obligations.
On February 16, 2016, the SEC announced its first deferred prosecution agreement (DPA) with an individual in an FCPA case. In that case, the SEC found that a Massachusetts-based technology company and its Chinese subsidiaries provided non-business related travel and other improper payments to Chinese government officials to win business. The SEC deferred FCPA charges for three years against a former employee at one of the Chinese subsidiaries because of his significant cooperation with the SEC’s investigation. The company and its subsidiaries agreed to pay $13.622 million and $14.54 million, respectively, to settle the FCPA charges as part of a non-prosecution agreement.
In another FCPA matter, the SEC announced in June that it had entered into non-prosecution agreements (NPAs) with two companies accused of FCPA violations after the companies self-reported the violations promptly, cooperated extensively with the SEC, and agreed to pay disgorgement. According to the NPAs, the companies: “(1) [r]eported the situation to the SEC on their own initiative in the early stages of internal investigations; (2) [s]hared detailed findings of the internal investigations and provided timely updates to enforcement staff when new information was uncovered; (3) [p]rovided summaries of witness interviews and voluntarily made witnesses available for interviews, including those in China; (4) [v]oluntarily translated documents from Chinese into English; (5) [t]erminated employees responsible for the misconduct; and (6) [s]trengthened their anti-corruption policies and conducted extensive mandatory training with employees around the world with a focus on bolstering internal audit procedures and testing protocols.”
And in a financial reporting case filed by the SEC in March (described in more detail below), the SEC entered into a deferred prosecution agreement with the former board chairman of a developmental-stage technology company alleged to have misled investors about its products. According to the SEC, the chairman became aware of the company’s inaccurate press releases but failed to ensure that they were corrected. Under the terms of the DPA, the former company chair agreed to provide ongoing cooperation in the SEC’s continuing federal litigation against company executives; he also agreed to resign all positions he held as an officer or directory of a public company.
Finally, in March, the SEC for the first time penalized an individual for backing out of a cooperation agreement. The SEC broke off its cooperation deal with Thomas C. Conradt, who testified in the SEC’s insider trading trial against two individuals, saying that he broke his vow to testify truthfully by feigning a fuzzy memory and denying facts that he had previously provided to federal authorities. Judge Rakoff of the Southern District of New York, who presided over the trial, found that Conradt “materially varied from [his] testimony at his deposition… in ways that indicate that Conradt was intentionally watering down his prior testimony in contravention of his cooperation agreement and . . . in contravention of the truth.” Rather than the $2500 in disgorgement that Conradt had agreed to pay under his cooperation agreement, the court ordered that he pay penalties of $980,000.
The number of SEC whistleblower awards has continued to mount since the implementation of the Dodd-Frank bounty regime. According to the agency’s 2015 annual whistleblower report, the SEC received over 4,000 tips–up 8% from fiscal year 2014 and 30% from the program’s first full year in 2012. And since the release of that report, there has been a spate of additional awards. Among those reported in the first half of 2016:
In addition to using these public announcements of significant cash awards to incentivize potential whistleblowers to come forward, the agency took several opportunities to call out companies which had failed to treat internal whistleblower claims with adequate seriousness or, in the eyes of the SEC, had dissuaded potential whistleblowers from approaching the government.
For example, in a financial fraud case described in greater detail below, the SEC specifically criticized the company’s alleged failure to adequately address an internal whistleblower complaint in its settled order instituting administrative proceedings. According to the SEC, the company identified the legal and accounting issues raised by the complaint, but did not seek legal or accounting opinions about the propriety of the questioned practice, and thereafter closed its internal investigation based on “insufficient inquiry.”
In addition, the SEC for the second time sanctioned a company for using employee agreements viewed by the agency as impeding employees from voluntarily providing information to the SEC. In a case against a large broker-dealer (also described in greater detail below), the SEC included allegations that the firm violated Exchange Act Rule 21F-17, which prohibits taking any action to impede someone from informing the SEC about a possible securities law violation. According to the SEC’s settled order instituting proceedings, the firm’s severance agreements included language prohibiting departing employees from disclosing confidential information absent a formal legal requirement or company authorization, which the SEC viewed as precluding employees from voluntary reporting information to the government. The SEC further noted that, while the language was later revised to allow communications with the SEC, it limited such information to the facts and circumstances surrounding the severance agreement itself.
As discussed at length in our reports over the past few years, one of the most talked-about trends in SEC enforcement has been the agency’s increasing use of administrative proceedings rather than federal court trials for contested actions. A number of respondents who had been charged in administrative proceedings filed civil injunctive actions seeking to enjoin the proceedings, typically raising constitutional challenges under the Appointments Clause to the manner in which SEC administrative law judges are appointed. After some initial success at the district court level, the Courts of Appeal have consistently rejected these challenges on jurisdictional grounds, holding such constitutional challenges could not be pursued in stand-alone injunctive actions; rather, all four Circuits to have considered the issue (including two June 2016 decisions) have required the respondents to go through the administrative proceedings process and raise the issue on appeal.
There are a couple cases in which these constitutional challenges have been raised before the Commission, rejected, and taken up on appeal to the DC Circuit. At the time this report went to press, one of these matters had been briefed and argued before the Court, with a decision still pending. Meanwhile, at least anecdotally it appears that the SEC has stepped back somewhat from its increased reliance on administrative proceedings, with most of its more high profile pieces of litigation this year filed in federal court.
Notably, just as this report went to press, the SEC announced on July 13 that it had adopted amendments to its Rules of Practice governing administrative proceedings. These amendments, first proposed in late 2015, are intended to provide some additional discovery rights, and expand certain timelines (among other things), for parties to such proceedings. We previously addressed the proposed rule changes in a client alert, and anticipate much discussion of their benefits (and limitations) in the months ahead.
Most of the financial reporting fraud cases that the SEC brought in the first half of 2016 related to earnings management, often through improper asset valuations and delayed impairment charges, as well as other accounting tricks geared towards improving a company’s net income.
For example, in April, the SEC simultaneously announced a pair of enforcement actions involving inflated earnings. In one of the cases, a technology manufacturer was alleged to have inflated its financial results through a delayed write-down of excess inventory and improper warranty accruals. The company paid a $7.5 million penalty, and its former controller and former director of accounting also agreed to pay penalties of $50,000 and $25,000, respectively. A litigated action against the company’s former CFO and then-acting controller is ongoing. In the other, unrelated case, the SEC alleged that a battery manufacturer overstated and income by failing to impair investments in and receivables from one of the company’s largest customers. The former CEO and board chairman, former CFO, and former Chief Accounting Officer all reached settlements with the SEC and agreed to pay penalties. The SEC further settled with the audit firm engagement partner for his allegedly inadequate audit work. The engagement partner agreed to a two year suspension from appearing or practicing before the SEC as an accountant.
Also in April, the SEC instituted settled administrative proceedings against an outdoor recreation retailer and its CFO for allegedly failing to eliminate intercompany promotional fees in preparing the company’s financial statements. In so doing, the company understated its merchandise costs and boosted margin metrics that were touted to investors. The company its CEO agreed to settle various non-fraud charges by paying penalties of $1 million and $50,000, respectively.
In May, the SEC settled fraud charges against a hygiene and sanitation company. The SEC alleged that the company engaged in a scheme to manipulate reported financial results to predetermined targets, and improperly used reserve accounts to reduce losses. The company entered into a deferred prosecution agreement with the SEC, and without admitting or denying the charges, agreed to pay a $2 million penalty. The SEC concurrently filed charges against the company’s former CFO, Director of External Reporting, and Director of Financial Planning for their participation in the allegedly fraudulent earnings management scheme; one officer has settled and agreed to a permanent officer and director bar with no penalty based on his cooperation with the SEC, while the other two individuals are litigating. The U.S. Attorney’s Office also delivered criminal indictments against the three individuals.
In June, the SEC announced a settled administrative proceeding against a New York-based electronics company relating to charges of overstatement of profits using improper inventory accounting. The company, without admitting or denying the allegations, agreed to pay a penalty of $200,000. Also without admitting wrongdoing, the former Executive Vice President of Operations agreed to a penalty and a five-year bar from serving as an officer or director of a public company, and a former controller agreed to a permanent suspension from appearing as an accountant before the SEC.
Revenue recognition also continues to be a mainstay of SEC financial reporting fraud actions. For example, in February, the SEC charged a biopesticide company and its former Chief Operating Officer for allegedly concealing significant customer sales concessions from finance personnel and the company’s auditors in order to boost revenue. Continuing a theme from other recent enforcement actions, the SEC also alleged that the former COO had falsified his expense reports, using company funds to pay for various personal expenses. The company agreed to pay a $1.75 million penalty in order to settle the SEC’s charges. The U.S. Attorney’s Office for the Eastern District of California announced parallel criminal charges against the company’s former COO.
The following month, the SEC instituted cease-and-desist proceedings against a company that provides supply chain and logistics services to other companies. The SEC alleged that the company overstated its revenue by keeping vendor rebates rather than passing them on to customers and by marking up prices. According to the SEC, these practices resulted in five years of inaccurate financial statements, which the company restated. Without admitting or denying the allegations, the company agreed to pay a $1.6 million penalty. In another rebate case, the SEC settled non-scienter fraud charges against an agribusiness company relating to improper recognition of revenue from rebate programs. The SEC alleged that the company had insufficient internal accounting controls, which resulted in a misstatement of consolidated earnings during a three year period. Without admitting or denying the allegations, the company agreed to an $80 million settlement, which included retention of an independence compliance consultant. Three accounting and sales executives also agreed to penalties and bars with potential reinstatement.
The SEC also announced a pair of cases relating to the improper valuation of assets in the first half of 2016. In a January case which did not involve any allegations of fraud, the SEC alleged that a servicer of mortgages falsely represented that it fair-valued its assets in accordance with GAAP when, in reality, it relied on flawed valuations provided by a related party. The SEC further alleged that the company lacked adequate internal controls, which failed to prevent conflicts of interest caused by the dual role its chairman played in related party transactions. And in June, the SEC settled charges with two executives and an auditor of an oil and gas company relating to the improper valuation of certain oil and gas assets acquired by the company which resulted in a nearly 5000% increase in the company’s total assets and had a significant impact on stock price. Both executives agreed to pay civil monetary penalties, and also consented to five-year bars. The partner in charge of the company’s audit agreed to a three-year bar from appearing before the SEC as an accountant.
Beyond accounting improprieties, the SEC also brought a number of cases in the first half of 2016 relating to deficient disclosures. For example, the SEC alleged that a company that develops technologies for touchscreen devices misled investors into believing that a key product was in production when in fact only samples had been manufactured. The company, without admitting or denying the SEC’s allegations, agreed to pay $750,000 to settle the charges. The CEO and CFO are litigating, and the company’s former board chairman entered into a deferred prosecution agreement and agreed to a five-year officer and director bar.
The SEC also announced fraud charges against a biotech company and three of the company’s former executives, alleging that the company misrepresented the Food and Drug Administration’s level of concern about clinical trials for the company’s flagship drug. The company neither admitted nor denied the allegations, but agreed to pay a $4 million penalty to settle the SEC’s charges. The three former executives–the CEO, CFO, and chief medical officer–are currently litigating the charges. Similarly, the SEC charged a company for failing to fully disclose the difficulties of getting Environmental Protection Agency certification for an advanced technology truck engine. The SEC’s order instituting a settled administrative proceeding against the company alleged that the company misled investors regarding EPA approvals of the engine in 2011 and 2012. The company neither admitted nor denied the allegations, but agreed to pay a $7.5 million penalty. The SEC charged the company’s former CEO in federal court, and that litigation is ongoing.
Finally, in a case confirming that the financial crisis continues to reverberate, the SEC brought fraud charges against eleven executives and board members at a bank for concealing the extent of loan losses. The SEC alleged that the directors and officers used false appraisals, straw borrowers, and insider deals in order to report net income figures that diverged substantially from true income figures in both 2009 and 2010. Nine of the eleven directors and officers settled with the SEC, neither admitting nor denying the SEC’s charges. Each is permanently barred from serving as an officer or director of a public company. Two of the eleven executives charged are litigating.
While the SEC routinely includes charges regarding deficient internal controls alongside cases alleging fraud and false filings, the agency also continues to pursue stand-alone internal controls actions. In March, the SEC instituted settled administrative proceedings against a Texas-based oil company and several individuals, including two senior officers, in a case alleging deficient evaluation of the company’s internal controls and failures to maintain internal control over financial reporting. The SEC specifically called out the company’s insufficient accounting resources at a time it was undergoing significant revenue growth. The company, without admitting or denying the charges, agreed to a $250,000 penalty subject to bankruptcy court approval, and the officers agreed to pay civil penalties as well. Notably, the SEC also brought settled charges against the engagement partner at the company’s audit firm, as well as an independent consultant, for their inadequate assessment of the company’s internal control deficiencies.
In April, the SEC settled internal controls charges against a publicly-traded securities services firm relating to accounting errors in recording and reporting over-the-counter derivative trading gains at a subsidiary, and failures to timely prevent or detect the errors. The alleged errors resulted in an overstatement of operating revenues by $10 million and net income by $6 million. The company agreed to a civil monetary penalty of $150,000, and the settlement noted that the SEC considered remedial measures which the company had undertaken.
Many of the cases referenced above reflect the SEC’s growing use of stand-alone clawback actions under Section 304 of the Sarbanes-Oxley Act, requiring CEOs and CFOs, even though not accused of wrongdoing, to return incentive-based compensation based on financial results later restated by the company. In both the ModusLink and Marrone Bio cases, executives were ordered to reimburse the company for cash and equity incentive-based compensation that they received and failed to repay after the company’s restatements.
In other cases referenced above, including Logitech and IEC Electronics, the SEC noted in its press releases that it did not pursue clawback actions against the executives because they had already voluntarily reimbursed the company for incentive-based compensation received during the time of the alleged misconduct.
As noted above, many of the financial reporting cases pursued against issuers and their executives included related proceedings against the companies’ auditors. The SEC also brought a number of additional enforcement actions against audit firms and individual accountants, though, in contrast with some of the cases involving large audit firms in 2015, most of these involved smaller players in local markets.
In February, the SEC announced charges against California-based audit firm for multiple instances of improper professional conduct and audit failures in connection with their audits of a Chinese company. According to the SEC, the auditors learned that certain material information regarding an acquisition had been materially misstated or omitted from prior financial statements. The firm then performed procedures to confirm this, proposed corrections, but then failed to implement the changes, instead signing off on financial statements that repeated the earlier material misstatements. In addition, the audit firm, in connection with the 2011 year-end audit of the same company, allegedly failed to test VAT payments made by a subsidiary, relied solely on information provided by the company, and issued an audit report containing an unqualified opinion with materially misstated the Chinese company’s tax liabilities. The SEC also charged the engagement partner and manager responsible for the audits. The firm later reached a settlement with the SEC in which it agreed–without admitting or denying the allegations–to pay approximately $50,000 in disgorgement and an additional $50,000 civil monetary penalty. The engagement partner and manager also agreed to settlements, without admitting or denying the allegations, which included fines of $5,000 and $1,000, respectively, and suspensions from practice as accountants. The matter stemmed from the SEC’s Cross-Border Working Group, which focuses on companies that are publicly traded in the United States but have substantial foreign operations, and has enabled the SEC to file both fraud and non-fraud cases against foreign issuers, their executives, auditors, and other gatekeepers.
In April, a Texas audit firm agreed to a settlement with the SEC in connection with charges that it failed to register with the Public Company Accounting Oversight Board (“PCAOB”) and failed to maintain independence when conducting audits. According to the settlement order, the firm, after acquiring the assets of another accounting firm, continued to conduct audits under the predecessor firm’s name, despite the fact that it did not have the right to do so, was not licensed in Texas, and was not registered with the PCAOB. The settlement also included charges against the founding partner, President of Operations, and managing partner who served as engagement partner in connection with each of the relevant audits. Specifically, the SEC alleged that the engagement partner knew or was at least reckless in knowing that the firm was not properly licensed or registered with the PCAOB and that he failed to issue audit reports with engagement quality reviews. In addition, the SEC alleged that the firm lacked independence because the principal of its predecessor firm became CFO of the audit client. All parties settled with the SEC without admitting or denying the findings, with the firm paying over $300,000 in disgorgement, prejudgment interest, and civil penalties, and the individuals paying civil penalties in various amounts and agreeing to suspensions. Separately, the SEC instituted litigated administrative proceedings against the predecessor firm, its principal, and certain other affiliated accountants for failure to conduct audits and reviews according to PCAOB standards.
Also in April, the SEC filed a settled order with a Maryland-based accounting firm and one of its partners for conducting deficient surprise examinations of an investment adviser client. According to the SEC, in connection with the investment adviser’s president secret theft of money from accounts belonging to professional athletes, the firm engaged in improper professional conduct by failing to adequately consider fraud risk factors and by filing paperwork with untrue statements regarding client assets. Without admitting or denying the allegations, the firm and its partner consented to the SEC’s order, agreeing to suspensions, disgorgement of over $25,000, and penalties of $15,000 each.
Most recently, on June 6, the SEC announced settled charges against a Michigan-based audit firm and four related individuals for engaging in improper professional conduct and failing to comply with PCAOB standards in connection with the audits of nine issuer clients. According to the SEC, the firm failed to comply with PCAOB standards including: obtaining sufficient evidence to support audit opinions; evaluating the reasonableness of accounting estimates made by management; properly documenting procedures; and properly supervising audits. For one of the audits at issue, the firm allegedly used audit testing prepared for and performed by a different accounting firm for a different audit, as well as duplicate or near duplicate paperwork from audits of other clients. In order to settle the matter, the firm and individuals each consented to relief including civil penalties and individual suspensions from practicing before the SEC.
The Division of Enforcement, and the Asset Management Unit in particular, are maintaining their focus on the fees and expenses charged by investment advisers and private fund managers, as well as by mutual fund advisers.
In March, the SEC instituted settled cease-and-desist proceedings against an Atlanta-based adviser to high net worth individuals and institutional investors, and its Chief Compliance Officer, for calculating and charging advisory fees in a manner different from that provided for within client advisory agreements. The firm agreed to pay disgorgement and prejudgment interest on the improperly charged fees, while its principal agreed not to act as a compliance officer of any regulated entity for three years.
Also in March, the SEC instituted settled proceedings against three AIG affiliates for having allegedly collected approximately $2 million in extra fees by placing mutual fund clients in share classes that charged fees for marketing and distribution, despite the clients’ eligibility to buy shares in fund classes without those charges. The Commission noted that the advisers did so without disclosure of this conflict of interest. The three firms settled without admitting or denying wrongdoing, and agreed to disgorge its fees and pay a $7.5 million penalty.
In May, the SEC filed a litigated court action against a Connecticut-based mutual fund manager as well as its founder and CEO. The Commission alleged that the firm moved investors’ money into newly-created mutual funds that charged higher fees without investors’ authorization. As a result, the firm purportedly collected almost $111,000 in additional fees without providing any additional services. The SEC also alleged that, in connection with this conduct, the firm made misleading disclosures in its Form ADV. The Commission’s complaint seeks permanent injunctions, disgorgement, and a civil penalty.
The same day, the SEC also brought charges against a Nashville-based adviser and its owner for allegedly manipulating the firm’s month-end trading in order to circumvent the funds’ fee structure and collect extra monthly fees. The adviser and its owner agreed to an interim order restricting them from accessing their own investments in the funds and prohibiting them from collecting any further fees until they satisfy the high water mark in the funds’ fee structure. Without admitting or denying the allegations, the firm also agreed to a preliminary injunction from violating the antifraud provisions of the federal securities laws.
In June, the SEC brought fraud charges against a Florida-based firm and its controlling principal, alleging that they charged investors additional undisclosed incentive fees of 40-50% of profits, and made various false claims regarding the firm’s investment track record. The matter is litigating.
The SEC continued to level broad charges against advisers that various business practices constituted improper or inadequately disclosed conflicts of interest.
In March, the SEC commenced a litigated administrative proceeding against the principal of a Georgia-based hedge fund adviser for alleged front-running. According to the SEC, the adviser invested the majority of the fund’s assets in a single security in which he had also personally invested, to the point where the fund held more than 10% of the company’s outstanding common stock. As the stock price began to plunge, he allegedly sold the shares he held in his personal account and two other accounts he controlled, allowing him to receive prices higher than the fund received when he subsequently sold the fund’s shares. He is further alleged to have sold shares on behalf of a favored investor ahead of sales by the fund, and to have purchased put options for himself and family members in advance of the fund’s liquidation of its shares, thereby profiting from the decline brought on by the large sell-off.
In June, the SEC alleged that a North Carolina-based private fund adviser failed to disclose conflicts of interest arising out of his steering $11.5 million of investor funds into real estate projects in which he had an ownership interest or controlled. According to the SEC, the adviser also misled investors about the performance and valuation of these investments. Without admitting or denying the allegations, the adviser agreed to a partial settlement which barred him from any future sale of pooled investment vehicles and subjected him to potential future disgorgement and penalties.
The SEC also brought a number of cases involving “cherry picking,” or the allocation of profitable trades to affiliated or favored client accounts. In April, the Commission instituted litigated administrative proceedings against a Southern California adviser and its owner, alleging that they engaged in a cherry-picking scheme by allocating profitable trades to certain favored clients, despite the firm’s internal policies requiring equitable trade allocation. The same day, the SEC simultaneously announced that it had filed settled charges against another California adviser, alleging that he allocated profitable trades to proprietary accounts and unprofitable clients. The adviser agreed to pay disgorgement and penalties of about $190,000, and to be barred from associating with an investment adviser or investment company.
Similarly, in June, the SEC filed a settled case against a UK-based investment adviser and its Chief Investment Officer, alleging that they breached their fiduciary duties by operating two private funds in a manner inconsistent with disclosures to investors. According to the SEC, although disclosures reflected that the two funds employed significantly different investment strategies, the funds’ investments overlapped significantly, and the adviser is alleged to have routinely allocated highly profitable trades to the fund in which he personally held a much higher stake despite such trades being more in line with the other fund’s strategy. Without admitting or denying the findings, the adviser agreed to pay a $400,000 penalty, and its CIO agreed to pay disgorgement and prejudgment interest of approximately $1.9 million and a $2,000 penalty.
In addition to cases challenging representations and omissions relating to fees and conflicts of interest, the SEC brought a number of actions alleging various other misrepresentations, including a pair of cases in which investment advisers tried to conceal their pasts from investors. At the beginning of the year, the SEC filed a settled action against a Manhattan-based investment adviser and its founder, alleging that they misled investors about a fund’s investment strategy and historical performance. According to the SEC, the adviser told investors that it would employ a scientific stock selection strategy, but in practice, the firm repeatedly deviated from that strategy, and then avoided disclosing heavy trading losses by using a misleading mixture of hypothetical and actual returns when providing the fund’s performance history. In addition, the adviser is alleged to have poured most of the fund’s assets into a single penny stock, and then making misleading and incomplete disclosures to fund investors about the value and liquidity of this penny stock investment. Without admitting or denying the findings, the adviser agreed to pay $2.9 million to fully reimburse fund investors for their losses, and its founder agreed to pay an additional $75,000 penalty and to be barred from the securities industry.
In February, the SEC charged a Boston-based investment adviser with advertising the overstated performance track record of a third-party entity’s investment strategy used by the adviser. In a prior action initiated in December 2014, the SEC brought proceedings against adviser F-Squared, alleging that it falsely claimed that its strategy had a history dating back to April 2001, when in fact much of that track record was actually hypothetical and backtested. In the new action, the SEC contended that the Boston firm offered F-Squared’s strategy to its own investors without verifying the performance claims. Without admitting or denying the findings, the adviser agreed to pay a $100,000 penalty.
The next month, the SEC instituted litigated administrative proceedings against an unregistered investment adviser and its principal, alleging that they (i) took extensive measures to hide the founder’s background, which included two felony fraud convictions, a bankruptcy filing, and other money judgments and liens; (ii) distributed false and misleading investment marketing materials; and (iii) misappropriated more than $1 million from fund assets and falsely characterized the withdrawals as assets of the funds. An administrative hearing is set for October.
Also in March, the SEC charged an Oregon-based investment firm and its senior executives with attempting to raise investor capital without adequately disclosing the firm’s deteriorating financial condition. Without admitting the allegations, the firm agreed to be preliminarily enjoined from raising any additional funds and agreed to the appointment of a receiver to marshal assets for distribution to investors.
And in a case against a manager of equipment leasing funds which had public reporting obligations under the 1934 Act, the SEC alleged that the fund failed to properly impair assets, leading to a material overstatement of net income (or understatement of net loss) in SEC filings. The company agreed to pay a $750,000 penalty to settle the SEC’s charges. In a separate case involving asset valuation–more notable for its claims involving insider trading, described in detail below–the SEC in June charged a pair of hedge fund portfolio managers with purportedly using sham broker quotes in order to mismark securities for an 18-month period, leading to artificially inflated fund returns, and resulting in a pay-out of more than $5.9 million in inflated management and performance fees to the investment adviser.
The first half of this year also saw a trio of misappropriation cases against fund principals. In March, the SEC brought fraud charges against a New Jersey-based fund manager whose firms marketed shares in promising pre-IPO tech companies in the Bay Area. The SEC alleged that the manager stole $5.7 million raised through the firms to prop up other funds and pay family-related expenses, including diverting the majority of the misappropriated money to his nephew, who had been barred from the securities industry in a prior SEC enforcement action involving the sale of securities in pre-IPO companies. The case highlights the SEC’s growing focus on high-visibility pre-IPO companies, and particularly advisers and funds purporting to create investment opportunities for investors seeking to invest in these companies.
Less than a week later, the SEC announced the settlement of similar charges against a San Francisco-based biotech venture capitalist, alleging that he siphoned money from one of his biotech funds to prop up other struggling businesses he owned and to fund his own lavish lifestyle. The firm and its principal agreed to pay disgorgement and penalties of nearly $6 million, and the principal agreed to be permanently barred from the securities industry. The SEC also entered into settlements with the firm’s chief legal officer and controller who, in their role as gatekeepers, were alleged to have facilitated the improper payments. The two agreed to permanent bars from appearing before the SEC as an attorney or accountant, respectively.
Then in May, the SEC announced settled fraud charges against a Pittsburgh-based financial adviser who allegedly took money from client accounts (including those of a number of professional athletes and other high net worth individuals). The SEC alleged that the adviser engaged in a Ponzi-like scheme to return money that was withdrawn without authorization. When faced with SEC inquiries, the adviser is alleged to have made false statements to SEC examiners and to have produced false deal documents to attempt to hide his misconduct. The adviser settled the charges without admitting or denying the allegations, with disgorgement and financial penalties to be set by the court at a later date.
Finally, in a case confirming the SEC’s determination to look beyond investment advisers themselves and scrutinize the actions of gatekeepers and other industry participants, the agency in June instituted settled proceedings against fund administrator Apex Fund Services for its alleged failure to identify indications of fraud while keeping records and preparing statements for various private funds for which it provided services. According to the SEC, despite clear indications that the funds were engaged in illegal activity, Apex failed to stop or correct prohibited transactions. False reports and statements prepared by Apex were ultimately used by the funds to communicate false information to the investors. Without admitting or denying the SEC’s findings, the firm agreed to retain an independent consultant and to pay a total of $352,449, including disgorgement and penalties.
The SEC also brought several compliance program-related cases. In April, the Commission charged an Iowa investment adviser with over $23 billion in assets under management with failure to supervise a principal who misappropriated client funds. The firm settled with a cease-and-desist order, and agreed to pay a civil monetary penalty of $225,000.
Also in April, the SEC brought charges against the owner of a Scottsdale, Arizona adviser, alleging the firm failed to maintain proper custody of client funds and failed to maintain adequate compliance policies and procedures regarding custody rules. The SEC also alleged that the firm made certain false representations in its Form ADV. The owner of the adviser settled the proceedings (and admitted wrongdoing), agreeing to a cease-and-desist order, a $45,000 civil penalty, and a bar from the securities industry for at least one year. Given that the SEC only infrequently requires defendants to admit wrongdoing as a term of settlement, the inclusion of an admission of wrongdoing in the agreement confirms the SEC’s heightened scrutiny of custody rule compliance.
As discussed in more detail in the Insider Trading section below, the SEC continues to scrutinize trading by funds and other institutional traders, including pursuing charges against firms for failing to implement adequate controls to prevent insider trading.
In May, the Commission instituted settled proceedings against the New York-based adviser to a $10 billion fund complex for failing to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information. Specifically, the SEC alleged that the firm failed to include its outside securities research and analysis consultant within its compliance program, and failed to monitor the consultant’s access to non-public information. As a result, the firm’s funds invested in four different companies for which the consultant was a director, and the consultant traded in securities which otherwise would have been off limits. Without admitting or denying the SEC’s findings, the firm agreed to pay a $1.5 million penalty.
And in a high-profile enforcement action announced in June involving trading by several hedge funds based on tips from a former FDA employee (discussed below), the SEC specifically challenged the hedge fund manager’s controls over insider trading. While the SEC has not charged the firm, in its complaint against the portfolio manager alleged to have traded based on improper tips of nonpublic information from a consultant to the firm, the SEC alleged that the firm’s policies failed to prevent the portfolio manager’s misuse of material nonpublic information. According to the complaint, the firm’s procedures “put the onus on employees to alert its Legal Department or CCO whenever there was a possibility that information they received was material nonpublic information,” and the firm allegedly “did little to prevent” the manager from violating the firm’s insider trading policies.
Finally, the SEC also brought a significant action against private equity firm Blackstreet Capital Management in June. In the Commission’s first action of its kind against a private-equity adviser, the SEC instituted settled administrative proceedings against the firm and its managing member, alleging that they received transaction-based compensation in connection with the acquisition and disposition of portfolio companies without registering as a broker-dealer. (The action also included other allegations, including the firm’s assessment of undisclosed fees and undisclosed use of fund assets to pay for political and charitable contributions.) Without admitting or denying the allegations, Blackstreet and its principal agreed to pay over $3.1 million to settle the matter. This case calls into question a practice believed to be fairly common in the industry, and is likely to have broad ramifications for private equity funds who are not registered as or affiliated with a broker-dealer.
The first half of 2016 saw the SEC bring a variety of cases involving failures in disclosure and accounting by brokers and other large financial institutions, including for inadequate disclosures in dark pool trading systems and commercial mortgage-backed securities ratings.
In January, the SEC announced settlements with some of the largest operators of dark pools and other alternative trading systems. For example, the SEC alleged that Credit Suisse Securities had misrepresented that opportunistic traders would be kicked off its electronic communications network, improperly accepted sub-penny orders, and failed to disclose that confidential information was being sent out of the dark pool and that its software shared orders with two high frequency trading firms. Without admitting or denying the allegations, the firm agreed to pay $30 million penalties to each of the SEC and the New York Attorney General, as well as $24.3 million in disgorgement and prejudgment interest.
In February, a former Deutsche Bank research analyst agreed to pay a $100,000 penalty to settle charges that he certified a stock rating that was inconsistent with his personal views. The analyst issued a 2012 research report on discount retailer Big Lots with a “BUY” recommendation, and, pursuant to Regulation AC, certified that the report accurately reflected his own beliefs about the company and its securities. However, according to the SEC, the analyst in private conversations with clients and internal personnel expressed reservations about the retailer and said he issued the “BUY” recommendation to preserve his relationship with the company’s management. The analyst, who did not admit or deny the SEC’s findings, also agreed to a suspension from the securities industry for one year.
Also in February, the SEC brought litigated charges against a New York lending company and its principal, alleging that they falsely stated that the company’s financial statements had been audited and would continue to be within 90 days of the end of each fiscal year, when in fact no audits occurred until years later. The SEC further alleged that they misled investors about the “extent and expertise” of management, and sent monthly account statements that failed to disclose that the loans they had financed were likely unrecoverable. In addition, the SEC brought charges against the placement agent, as well as its president and its owner, charging that they learned of the fraud but continued to solicit sales based on misleading private placement memoranda.
In May, the SEC initiated a litigated court action against a former executive of a publicly-traded financial holding company for engaging in a $20 million scheme to defraud investors by charging hidden and unauthorized mark-ups on securities trades. According to the SEC, the executive applied mark-ups to transactions made on behalf of large institutional clients buying and selling significant quantities of securities when changing fund managers or investment strategies. When one customer noticed some of the hidden mark-ups, the executive allegedly directed others at the firm to characterize them as a “fat finger error” or “inadvertent commissions.” The SEC’s action followed criminal charges filed by the U.S. Attorney’s Office for the District of Massachusetts which are predicated on the same conduct.
And in June, the SEC filed settled charges against Merrill Lynch for allegedly inadequately disclosing fees for a proprietary volatility index fund. This was the agency’s second ever case involving misleading statements in structured notes, which are debt securities issued by a financial institution in which returns are linked to a reference asset, such as equity indexes, interest rates, commodities, or foreign currencies. The SEC alleged that the firm failed to adequately disclose the “execution factor,” which imposed a cost of 1.5 percent of the index value each quarter. Without admitting wrongdoing, Merrill Lynch agreed to pay a $10 million penalty.
Several years after the mortgage crisis, the SEC continues to pursue enforcement actions relating to the sale of mortgage-backed securities. In a March 2016 case involving commercial mortgage backed securities (“CMBS”), the SEC alleged that a Standard & Poor’s senior researcher failed to disclose significant assumptions in a study supporting then-new criteria for rating CMBS. The study looked to Great Depression era commercial mortgages and concluded that average commercial mortgage pool losses were 20% under levels of economic stress like those found during the Great Depression. However, the SEC alleged that the analyst’s undisclosed assumptions understated the risk of loss and failed to properly model key aspects of modern CMBS. The analyst agreed to pay a $25,000 penalty and be barred from working for any nationally recognized statistical rating organization.
In May, the SEC announced that a California-based mortgage company, as well as six of its senior executives, agreed to pay $12.7 million to settle charges related to the sale of residential mortgage-backed securities (“RMBS”). The SEC alleged that between March 2011 and March 2015, the company delayed depositing checks from borrowers who had been behind on their loans in order to claim that the loans remained delinquent. The firm then allegedly repurchased the loans at a discounted rate, and subsequently re-sold them into new RMBS pools at a higher price applicable to current loans. The six individual executives, who did not admit or deny the SEC’s allegations, agreed to pay disgorgement and penalties ranging from $50,000 to $200,000.
In other matters, the SEC filed settled charges against Canaccord Genuity Inc., a broker-dealer, for improperly initiating research on an issuer for which it was seeking to act as an underwriter. The SEC settled with J.P. Morgan Securities LLC on charges that the broker did not compensate advisors “based on [their] clients’ performance,” as stated in some marketing materials. And the SEC brought charges against the former CFO of broker KeyBanc Capital Markets for using “plug” entries to reconcile variances between ledgers, effectively overstating assets and income. The firm itself was not charged.
In one of the more significant broker-dealer developments of the first half of 2016, the Commission announced in June that Merrill Lynch agreed to pay $415 million in disgorgement and penalties to settle charges that it violated the SEC’s Customer Protection Rule. The Rule imposes certain requirements to avoid delays in returning customer securities in the event of a broker-dealer failure, including the creation of certain reserves. According to the SEC, the firm used customer cash that should have been deposited into a reserve account to instead fund complex option trades. The SEC further alleged that the firm held up to $58 billion of customer securities per day in accounts subject to general liens, rather than in lien-free accounts as the Commission contended was required. As part of the settlement, Merrill Lynch was required to admit certain of the SEC’s charges. The SEC also initiated a related litigated proceeding against the firm’s former Head of Regulatory Reporting.
In announcing the settlement, the SEC noted that the financial institution cooperated fully with the Commission’s investigation, and agreed to engage in extensive remediation, including retaining an independent compliance consultant and implementing a mandatory annual whistleblower-training program for all employees.
In conjunction with the above announcement, the SEC simultaneously announced a new sweep against other firms designed to detect abuses of the Customer Protection Rule. The new initiative will have two parts. The first part will encourage broker-dealers to proactively report potential violations of the Customer Protection Rule in exchange for potential cooperation credit and favorable settlement terms. Under the second part, the Enforcement Division, Division of Trading and Markets, and the Office of Compliance Inspections and Examinations will conduct risk-based examinations of certain broker-dealers to assess compliance with the rule.
The SEC settled several cases in the first half of 2016 where individuals or firms were accused of misusing confidential customer information, or failing to maintain adequate security measures to protect such information. First, in February, the SEC instituted settled proceedings against a broker who was alleged to have shared confidential customer information with an outside third party without the customers’ knowledge or consent. According to the SEC, the registered representative of an unnamed broker-dealer shared confidential information–including holdings in particular stocks, cash balances, and trade activity–relating to at least 14 of his customers’ accounts with an associate who had worked at his firm prior to a finding that he had engaged in unauthorized trading. The SEC further noted the broker’s improper use of his personal email account to transmit the information and avoid the firm’s security restrictions. The representative was suspended from associating with any broker or dealer for six months, and required to pay a civil penalty of $75,000.
Then in April and June 2016, the SEC settled charges related to the failure of two separate firms to protect private customer information. In the first matter, the SEC announced that a New York broker-dealer and its two co-owners agreed to settle charges that they violated rules requiring the firm to adopt written policies and procedures to protect confidential customer information and records, and to keep and maintain copies of all business communications. The SEC alleged that, among other deficiencies, the firm used personal email addresses to receive faxes from customers and other third parties. The faxes allegedly contained sensitive customer information, including names, addresses, social security numbers, bank and brokerage account numbers, and copies of driver’s licenses and passports. The firm and its principals agreed to pay the SEC a total of $150,000 in penalties.
In the second matter, the SEC instituted settled administrative proceedings alleging that Morgan Stanley Smith Barney failed to institute adequate technological safeguards to restrict employees’ access to customer data based on each employee’s legitimate business need. According to the SEC, these technical limitations allegedly enabled a former employee to download and transfer confidential data for approximately 730,000 accounts to a personal server at the employee’s home. A suspected third-party hack of the employee’s personal server apparently resulted in portions of the confidential information being posted online for sale. Without admitting or denying the SEC’s allegations, the firm agreed to pay a $1 million penalty.
The first half of 2016 also saw the SEC bring a first-of-its-kind case against a brokerage firm charged with violating regulations designed to prevent money laundering. On June 1, the SEC announced that a New York broker-dealer agreed to pay a $300,000 penalty for failure to file legally-mandated Suspicious Activity Reports (SARs) with bank regulators. Although the SEC has previously used federal securities laws to discipline firms for anti-money laundering failures, the case was first time the SEC has charged a firm solely for failing to file SARs. According to the SEC, over a five-year period some of the firm’s customers engaged in activity that should have triggered a SAR filing. This included, on more than one occasion, a customer trading in a security on a given day that exceeded 80 percent of the overall market volume.
And in February, the SEC announced that a Miami-based broker-dealer agreed to pay a $1 million penalty to settle changes that it violated customer identification program (“CIP”) protocols by allowing foreign entities to trade securities without verifying the identities of non-U.S. citizens who beneficially owned such securities. Federal law requires all financial institutions to maintain sufficient CIP rules to ensure that institutions do not become vehicles for money laundering or terrorist financing. According to the SEC, for about 10 years the firm maintained a brokerage account for a Central American bank that was purportedly trading for its sole benefit. In actuality, 13 non-U.S. corporate entities and 23 non-U.S. citizens were the beneficial owners of the bank’s securities, and they were able to execute more than $23 million in transactions through the bank’s brokerage account.
Finally, in January 2016, the SEC announced a settled administrative action against Goldman Sachs & Co. relating to compliance with regulations governing the process of locating securities for customers to borrow for short selling, known as Reg. SHO. When customers want to short-sell a security, they typically ask a broker-dealer to locate the stock in question. A broker-dealer granting a “locate” represents that the firm has borrowed, arranged to borrow, or reasonably believes it could borrow the security to settle the short sale. According to the SEC, the firm allegedly provided locates to customers when it had not performed an adequate review of the securities to be located. The SEC further alleged that the firm inaccurately recorded the locates in a log. In settling the matter without admitting or denying the SEC’s allegations, the firm consented to pay a $15 million penalty. According to the SEC’s order, the settlement took into account the firm’s remedial efforts.
One of the more significant insider trading cases of the past year or so came in June, where the SEC sued two hedge fund managers and a former government official who allegedly served as a source of material non-public information. One of the hedge fund managers, now deceased, allegedly received information from an outside consultant, who worked for a trade association representing generic drug manufacturers and distributors but had previously spent over at decade at the U.S. Food and Drug Administration. According to the SEC, the consultant obtained confidential information about upcoming FDA drug approvals from former colleagues at the FDA and relayed this information to the hedge fund manager, who made nearly $32 million in profits for his funds by trading ahead of public announcements of the FDA approvals. The trader is alleged to have also shared these tips with another hedge fund manager, who was similarly charged by the SEC. The United States Attorney’s Office for the Southern District of New York announced parallel criminal charges against all of those involved. This case confirms the SEC’s continued scrutiny of private fund managers and, in particular, their use of expert consultants as sources of information.
The SEC also brought several other insider trading cases against securities industry professionals in the first half of the year. In March, the SEC filed a settled injunctive action against a trader alleged to have made over $700,000 after being tipped about a confidential merger by a friend who worked for an investment adviser. The tipper, who was previously charged by the SEC in 2013, had allegedly learned of an upcoming merger when a client of his firm–a board member of the pharmaceutical company to be acquired–sought financial advice related to the acquisition. The friend ultimately entered a guilty plea in a parallel criminal action and was permanently barred from the securities industry.
In April, the SEC brought litigated charges against a research analyst who allegedly traded after his firm was approached by the potential acquirer of a home security company looking to finance the transaction. According to the SEC, after reviewing several confidential deal-related documents, the analyst bought call options using his mother’s brokerage account. The SEC did not suggest any misconduct on the part of the companies involved in the transaction. The United States Attorney’s Office for the Southern District of New York announced criminal charges against the analyst as well. The SEC’s press release touted other examples of recent cases in which traders had attempted to evade detection by trading through relatives’ accounts.
In May, the SEC filed a litigated case against an investment banker alleged to have been divulging confidential information about potential mergers and acquisitions involving the bank’s clients to a friend, a plumber, in exchange for cash and free bathroom remodeling services. The friend, who had purchased securities in 10 different companies ahead of deal announcements based on the tips, yielding $76,000 in ill-gotten profits, was also named in the complaint. Both men were charged in parallel criminal actions in the Southern District of New York.
The SEC also brought charges against company executives, senior management, and board members who exploited their access to their companies’ confidential information for their own personal gain.
In February, the SEC charged the Vice President of Tax at an electronics company with trading ahead of an earnings announcement based on his knowledge of the financial results. According to the SEC, the vice president purchased 17,000 shares of the company’s stock the day before the announcement, netting over $130,000 when the shares rose more than 12% on the news of stronger-than-expected earnings. A parallel criminal action was also filed.
In May, a senior executive at a Silicon Valley semiconductor equipment manufacturer agreed to settle allegations that he traded on information received from the board member of an acquisition target that was trying to solicit a competitive bid from his company. The executive is alleged to have served as a conduit of information between the officer at his company responsible for analyzing acquisition opportunities and the board membership of the target company. Based on the information he received, the executive bought 105,000 shares of the target company’s stock and tipped his brother, who bought 1,000 shares. Once a merger agreement was publicly announced, the executive sold his shares for approximately $250,000 in illegal profits. Without admitting or denying the allegations, the executive agreed to pay over half a million dollars in disgorgement and penalties.
Also in May, the SEC charged the board member of a dairy company and a well-known sports gambler to whom he owed money with engaging in a $40 million insider trading scheme. According to the SEC, the director repeatedly provided non-public information about corporate developments, which the tippee used for personal profit and to offset the tipper’s gambling debts. The SEC further alleged that the gambler provided the board member with a prepaid cell phone and developed code words to be used to relay tips. Related criminal charges have also been filed. Notably, the SEC’s complaint also named professional golfer Phil Mickelson, who owed a debt to the same sports gambler, as a relief defendant. While the SEC did not allege wrongdoing on the part of Mickelson, the agency alleged that he netted approximately $1 million in trading profits based on trades he made at the urging of the gambler, which he agreed to pay back (with interest) without admitting liability. The SEC’s somewhat novel position that a relief defendant who is not alleged to have personally engaged in illegal insider trading must nonetheless return his profits because the source of the information acted improperly raises interesting questions about the reach of the SEC’s authority.
In June, the SEC announced insider trading charges against a former global vice president of a software company and three friends he tipped in exchange for kickbacks. The software executive, by virtue of his position, became aware of plans for a merger between his company and another software company. The executive allegedly tipped his friend, whose business was suffering, about the impending merger. The friend, his brother, and another mutual friend purchased call options in the target company, netting over $500,000 after the merger was announced and paying the tipper $90,000 in kickbacks. The SEC linked the same executive and his friend to suspicious trades made in 2007 in advance of a tender offer, which allegedly resulted in $42,000 in illegal profits, and charged them with an additional count of insider trading. The complaint was filed in federal court in Indiana.
The SEC pursued several additional cases against other professionals and company insiders, as well as those who misappropriated information from corporate insiders. In February, the SEC instituted settled administrative proceedings against the assistant controller of a retail chain, which was the subsidiary of a larger retail group. The controller is alleged to have purchased call options ahead of earnings announcements based on confidential sales data indicating stronger than expected performance. In addition, the controller learned of the retail group’s impending bid for another retail chain and purchased shares of the target company. When the acquisition was publicly announced, the controller sold his shares and obtained a profit. Without admitting or denying the findings, the controller agreed to pay disgorgement and penalties of $420,669, and to be permanently barred from serving as an officer or director of a public company.
In March, the SEC settled administrative proceedings against five individuals who traded the stock of an e-commerce company in advance of its acquisition by eBay. According to the SEC, the wife of an insider at the target company learned about the acquisition and shared the news with her friend, who traded on the information and also tipped her husband, her father, and another friend, who likewise traded on the information. The husband tipped another friend, who ultimately cooperated in the investigation. The e-commerce company’s stock went up 50% once the acquisition was announced, and the five individuals obtained illegal profits exceeding $160,000. The individuals agreed to pay a combined settlement of approximately $384,000 in disgorgement and penalties.
Also in March, a finance manager at a software company agreed to settle allegations that he bought put options after learning that the company would not meet earnings expectations, realizing a $9,000 gain when the stock price later fell. According to the SEC, the employee also purchased call options in a mobile phone company he learned his company planned to acquire, netting $175,000 in profits when the deal was announced. Pursuant to the settlement, the individual, who did not admit or deny the allegations, agreed to disgorge his illicit profits and pay a penalty of $184,132, and to be barred from serving as an officer or director of a publicly-traded company for five years. Neither the software company nor the mobile phone company was a party to the settlement or accused of any wrongdoing.
In June, the SEC filed a litigated action against a pharmaceutical company employee and his stockbroker friend with insider trading. The pharmaceutical employee obtained through his company clinical and business data about other pharmaceutical companies, including information about potential acquisitions, and traded on that information to gain approximately $116,000 in illegal profits. In addition, he shared this information with a childhood friend, a stockbroker, who used the information to make trades for himself and his clients. The stockbroker realized at least $187,000 in profits for himself and $145,000 for his clients. The United States Attorney’s Office for the Southern District of New York is pursuing criminal charges against both men.
Also in June, the SEC settled charges against an optical physicist, who was advising two private equity firms pursuing a buyout of a U.S.-based maker of optical semiconductor devices. The SEC alleged that the physicist traded on confidential information obtained in the course of performing due diligence and attending acquisition-related meetings. The physicist began stockpiling shares of the optical device maker before the acquisition was announced and reaped nearly $370,000 in illicit profits when the stock rose 15% following the deal announcement, in breach of the duty he owed to the firms for which he was consulting. Without admitting or denying the SEC’s allegations, the consultant agreed to disgorge the trading profits and pay interest and a penalty amounting to a total settlement of over $756,000.
As discussed in our 2015 Year-End Securities Enforcement Update, on October 5, 2015, the Supreme Court denied the government’s petition for certiorari in United States v. Newman, precluding additional review of the Second Circuit’s decision. Left to stand, Newman arguably narrowed the scope of tipper-tippee liability by requiring prosecutors to prove that the insider disclosed information in exchange for a personal benefit of monetary value. While more of an issue for criminal prosecutors, given the higher burden of proof, the decision represents a setback for SEC civil actions as well.
That said, Newman‘s impact on the SEC may be overstated. For example, in an April 15, 2015 ruling by Judge Jed Rakoff of the Southern District of New York, the court distinguished civil and criminal insider trading liability under Newman based on the tippee’s level of knowledge or awareness of the tipper’s pecuniary benefit. The court held that while criminal liability for insider trading requires a tippee to act with actual knowledge that the tipper will receive a benefit, civil liability requires only reckless disregard that the original tipper is likely to benefit. That action proceeded to jury trial, and in a March 2016 verdict the jury found both tippees liable for insider trading.
The same Judge Rakoff, sitting by designation on the Ninth Circuit Court of Appeals, again pressed back on Newman in the July 2015 decision in United States v. Salman. In Salman, the court held that providing nonpublic information to the alleged tipper’s brother constituted a personal benefit despite the lack of a clear pecuniary gain. The Supreme Court granted a petition for certiorari on January 19, 2016 to review Salman. Specifically, the Court will consider whether the personal benefit requirement must involve “at least a potential gain of a pecuniary or similarly valuable nature,” per Newman, or whether Salman‘s close friendship or family relationship between the insider and tippee is sufficient.
Finally, in March 2016, the U.S. District Court for the District of Rhode Island also took an expansive approach to tipping liability, notwithstanding Newman, in denying a defendant’s motion to dismiss. In SEC v. Andrade, the SEC alleged that a former bank director illegally tipped three friends and business associates about a potential bank acquisition. The court found both that the insider had close personal ties with the tippees and that the tippees were aware of the potential benefits the tipper would receive. The court also noted that even under Newman, the SEC does not need to prove a “specific tangible benefit,” but “at most, it needs to plead specific facts showing that Defendants’ relationship is ‘meaningfully close’ enough to support an inference that there is ‘at least a potential gain of a pecuniary or similarly valuable nature.'” Because the SEC’s complaint alleged such a connection, the court denied the defendant’s motion to dismiss. The litigation remains ongoing.
After a somewhat slower pace in fiscal year 2015, the SEC’s Municipal Securities and Public Pensions Unit got busy in the first half of calendar year 2016, with a number of high profile enforcement actions.
In January, the SEC announced a settlement with a Massachusetts financial institution and its former senior vice president in connection with an alleged pay-to-play scheme to win Ohio public pension fund contracts. According to the SEC, the bank, through an outside fundraiser and lobbyist, allegedly entered into an agreement with the deputy treasurer of Ohio, in which the bank made illegal campaign contributions in order to obtain lucrative contracts. Without admitting or denying the allegations, the bank agreed to pay $12 million in disgorgement and penalties, and its officer agreed to pay approximately $175,000 in disgorgement and a $100,000 penalty. The SEC also filed a litigated complaint against the lobbyist for his role.
In March, the SEC initiated settled proceedings against California’s largest agricultural water district and its general manager and former assistant general manager for misleading investors about its financial condition in connection with a $77 million bond offering. According to the SEC, the district engaged in “extraordinary accounting transactions” to reclassify funds to maintain its debt service coverage ratio, which measures an issuer’s ability to make future bond payments. According to the SEC, the district’s general manager allegedly referred to these transactions as “a little Enron accounting” when describing them to the board of directors and customers. The water district became the second municipal issuer to pay a financial penalty in connection with an SEC enforcement action, agreeing to pay $125,000. The general manager and former assistant general manager paid penalties of $50,000 and $20,000 respectively.
In April, the town of Ramapo, New York, as well as its local development corporation and four town officials, were charged with allegedly hiding the town’s financial situation from municipal bond investors in the wake of costs from the building of a baseball stadium and other declining sales and property tax revenues. According to the SEC, town officials “cooked the books” to falsely show positive balances when the town actually had balance deficits as high as $14 million. These balances were reflected in offering materials used in connection with 16 municipal bond offerings by the town or its development corporation. The town supervisor also allegedly misled a credit rating agency and told other town officials to quickly refinance the short-term debt in order to realize the purported financial results. The case is being litigated, and the U.S. Attorney’s Office for the Southern District of New York has also filed a parallel criminal action against the town supervisor and a former town attorney.
In May, the SEC filed a settled action against the mayor of Harvey, Illinois, in connection with a series of allegedly fraudulent bond offerings by the city. (The city itself had been sued by the SEC in 2014, in an emergency action freezing an ongoing bond offering.) According to the SEC, city officials diverted funds that they told investors would be used to develop a Holiday Inn to instead fund operational costs, including the city’s payroll; the new complaint alleged that the mayor exercised control over the city’s operations and signed important offering documents relating to the bonds. Without admitting or denying the allegations, the mayor agreed to pay $10,000 and to never participate in a bond offering again.
Most recently, in another Illinois matter (also arising out of a 2014 enforcement action), the SEC announced a settlement with the CEO of a Chicago charter school operator alleged to have misled investors in connection with a $37.5 million bond offering to build charter schools. According to the SEC, the executive negligently approved and signed a bond offering statement that omitted information about contracts between the charter schools and the organization’s chief operating officer’s brothers. The SEC alleged that he signed grant agreements with the Illinois Department of Commerce to build charter schools, in which the organization certified that no conflicts of interest existed. Without admitting or denying the allegations, the CEO agreed to pay a $10,000 civil penalty and to a bar from participation in municipal bond offerings.
Finally, as discussed in our 2015 mid-year and year-end updates, the SEC Enforcement Division continued to roll out settlements against muni bond underwriters under the agency’s Municipalities Continuing Disclosure Cooperation Initiative (MCDC). The Initiative encourages municipal bond underwriters and issuers to self-report material misstatements and omissions in municipal bond offering continuing disclosures in exchange for favorable settlement terms. In February, the SEC announced actions against another 14 underwriting firms, bringing its total to 74 charged underwriters under the Initiative. The firms agreed to pay civil penalties based on the number and size of faulty offerings identified, and to retain an independent consultant to review policies and procedures going forward. Although the Initiative has now concluded, the SEC is continuing to investigate issuers who may have had deficient disclosures.
Taking advantage of the SEC’s broadened reach following the 2010 enactment of Dodd-Frank, the SEC this year filed its first two enforcement actions against municipal advisors.
First, in March, the SEC alleged that a Kansas-based municipal advisor, its CEO, and two employees failed to disclose a conflict of interest in connection with bond offerings that were underwritten by a broker-dealer for which all three of the firms’ employees also worked as registered representatives. The employees did not inform their client, an unnamed city, of this relationship, and therefore of the financial benefit they would obtain from serving both roles. Without admitting or denying the allegations, all parties settled with the SEC, agreeing to bars, disgorgement of approximately $290,000 by the advisor, and civil penalties ranging from $17,500 to $85,000.
And in June, the SEC announced settled administrative proceedings against two California-based municipal advisory firms and certain of their executives. According to the SEC, the principal of one of the firms, who advised school districts about their hiring process for financial professionals, shared information about the hiring process with the other firm, which was seeking to advise the same school districts. According to the SEC, while the school districts were aware of the relationship between the two firms, they did not necessarily know that information (such as potential interview questions) had been shared. Without admitting or denying the allegations, the advisors and their principals agreed to be censured and to pay monetary fines.
This spring, the SEC filed several actions highlighting its continued efforts to demonstrate the international reach of the U.S. securities laws. In April, the SEC charged two individuals and their companies with fraud for allegedly making false statements and misusing funds acquired under the EB-5 Immigrant Investor Program. The EB-5 Program provides a method for foreign nationals to obtain a green card when they invest a requisite amount of capital in the United States, thereby creating jobs for U.S. workers. The SEC alleges that investors were told they were investing in a ski resort and a biomedical research facility, but instead the money was used to fund deficits in earlier projects and for personal expenses. The case is part of an ongoing SEC initiative to curb abuses in the EB-5 Program.
In June, the SEC announced a settlement with Ethiopia’s electric utility to pay almost $6.5 million for its failure to register bonds it had offered and sold to U.S. residents of Ethiopian descent, in contravention of U.S. securities laws. In announcing the action, an SEC official commented, “Foreign governments are welcome to raise money in the U.S. capital markets so long as they comply with the federal securities laws, including registration provisions designed to ensure that investors receive important information about prospective investments.”
Finally, one Enforcement-related development from the first half of 2016 warrants some attention. In April, the SEC appears to have vacated an earlier order that would have allowed an investment professional to return to work in the securities industry after serving a five-year bar as part of an SEC settlement. The SEC originally issued an order granting a request by FINRA that the individual be authorized to associate with a broker-dealer. However, shortly thereafter, the SEC vacated that order, noting that FINRA had withdrawn the application. The exact circumstances of that order are unclear. According to press reports, the individual voluntarily withdrew the request; however, these reports also suggested that some SEC Commissioners questioned the original decision (which had been made on behalf of the SEC by the Division of Trading and Markets). If it is indeed the case that some members of the Commission are reluctant to allow settling parties to again work in the securities industry even after a time-limited bar has expired, it could raise serious fairness concerns and make it more difficult for parties to contemplate settling with the agency.
 For more on the statistical breakdown of 2015 enforcement actions, see M. Fagel, SEC Enforcement By The Numbers, Law360 (Mar. 8, 2016), available at www.gibsondunn.com/publications/Pages/SEC-Enforcement-By-The-Numbers.aspx.
 SEC Speech, Andrew Ceresney, Securities Enforcement Forum West 2016 Keynote Address: Private Equity Enforcement (May 12, 2016), available at www.sec.gov/news/speech/private-equity-enforcement.html; SEC Speech, Mary Jo White, Keynote Address at the SEC-Rock Center on Corporate Governance Silicon Valley Initiative (Mar. 31, 2016), available at www.sec.gov/news/speech/chair-white-silicon-valley-initiative-3-31-16.html.
 SEC v. Graham, No. 14-cv-13562, 2016 WL 3033605 (11th Cir. May 26, 2016)
 For additional analysis, see Gibson Dunn Client Alert, Eleventh Circuit Limits SEC Power to Seek Disgorgement and Declaratory Relief (May 27, 2016), available at www.gibsondunn.com/publications/Pages/Eleventh-Circuit-Limits-SEC-Power-to-Seek-Disgorgement-and-Declaratory-Relief.aspx.
 5 U.S.C. § 552(b)(7)(A) (2016).
 In re Lions Gate Entm’t Corp. Sec. Litig., No. 14-cv-5197 (JGK), 2016 WL 297722 (S.D.N.Y. Jan. 22, 2016).
 Lit. Rel. No. 23577, SEC Obtains $980,000 Penalty from Defendant Who Violated Cooperation Agreement (June 21, 2016), available at www.sec.gov/litigation/litreleases/2016/lr23577.htm.
 SEC, 2015 Annual Report to Congress on the Dodd-Frank Whistleblower Program, available at www.sec.gov/whistleblower/reportspubs/annual-reports/owb-annual-report-2015.pdf.
 In re ModusLink Global Sols., Inc., Joseph C. Lawler, Steven G. Crane, and Catherine L. Venable, Admin. Proc. File No.3-17171 (Mar. 15, 2016), available at www.sec.gov/litigation/admin/2016/33-10055.pdf.
 Hill v. SEC, No. 15-Cv-01801 (LMM) (11th Cir. June 17, 2016); Tilton v. SEC, No. 15-cv-2103, 2016 WL 3084795 (2d Cir. June 1, 2016); Jarkesy v. SEC, 803 F.3d 9 (D.C. Cir. 2015); Bebo v. SEC, 799 F.3d 765 (7th Cir. 2015), cert. denied, 136 S. Ct. 1500 (2016).
 See Gibson Dunn Client Alert, SEC Moves in the Right Direction . . . (Sept. 28, 2015), available atwww.gibsondunn.com/publications/Pages/SEC-Proposed-Amendments-to-Rules-Governing-Administrative-Proceedings.aspx.
 SEC Press Release, SEC Announces Settlement with Cabela’s and its CFO for Misleading Statements in Commission Filings and Earnings Releases (Apr. 26, 2016), available at www.sec.gov/litigation/admin/2016/34-77717-s.pdf.
 Lit. Rel. No. 23544, SEC Charges Corporate Officers with Earnings Management Scheme Fraud (May 24, 2016), available at www.sec.gov/litigation/litreleases/2016/lr23544.htm.
 SEC Press Release, SEC Charges Biopesticide Company and Former Executive With Accounting Fraud (Feb. 17, 2016), available at https://www.sec.gov/news/pressrelease/2016-32.html.
 In re ModusLink GlobSol, Inc., Joseph C. Lawler, Steven G. Crane, and Catherine L. Venable, Admin. Proc. File No.3-17171 (Mar. 15, 2016), available at www.sec.gov/litigation/admin/2016/33-10055.pdf.
 SEC Press Release, Monsanto Paying $80 Million Penalty for Accounting Violations (Feb. 9, 2016), available at https://www.sec.gov/news/pressrelease/2016-25.html.
 In re Miller Energy Resources, Inc., et al., Admin. Proc. File No.3-16729 (June 7, 2016), available at www.sec.gov/litigation/admin/2016/33-10089.pdf; www.sec.gov/litigation/admin/2016/33-10090.pdf; and www.sec.gov/litigation/admin/2016/33-10091.pdf.
 In re Int’l FCStone Inc., Admin. Proc. File No. 3-17207 (Apr. 12, 2016), available at www.sec.gov/litigation/admin/2016/34-77596.pdf.
 In re Thakkar CPA, PLLC, Gregory Scott Williford, CPA, Mahesh Thakkar, CPA, and Poorvesh Thakkar, Admin. Proc. File No. 3-17201 (Apr. 6, 2016), available at www.sec.gov/litigation/admin/2016/34-77542.pdf.
 In re David S. Hall, P.C. d/b/a The Hall Group CPAs, David S. Hall, CPA, Michelle L. Helterbran Cochran, CPA, and Susan A. Cisneros, Admin. Proc. File No. 3-17228 (Apr. 26, 2016), available at www.sec.gov/litigation/admin/2016/34-77718.pdf.
 In re Silberstein Ungar PLLC, Ronald N. Silberstein, CPA, Joel M. Ungar, CPA, Seth A. Gorback, and David A. Kobylarek, CPA, Admin. Proc. File No. 3-17277 (June 6, 2016), available at www.sec.gov/litigation/admin/2016/34-77997.pdf.
 SEC Press Release, AIG Affiliates Charged With Mutual Fund Shares Conflicts (Mar. 14, 2016), available at www.sec.gov/news/pressrelease/2016-52.html; In re Royal Alliance Assoc., Inc., et. al., Admin. Proc. File No. 3-17169 (Mar. 14, 2016), available at http://www.sec.gov/litigation/admin/2016/34-77362.pdf.
 Litig. Rel. No. 23549, SEC Charges Connecticut-Based Investment Adviser for Failure to Disclose Fees to Clients (May 31, 2016), available at www.sec.gov/litigation/litreleases/2016/lr23549.htm.
 Litig. Rel. No. 23560, SEC Charges Fort Myers, Florida-Based Investment Adviser and Manager in Fraudulent Fee-Siphoning Scheme (June 7, 2016), available at www.sec.gov/litigation/litreleases/2016/lr23560.htm
 SEC Press Release, SEC Announces Charges Against Two California-based Investment Advisers for Cherry-Picking Profitable Trades for Favored Accounts (Apr. 19, 2016), available at www.sec.gov/litigation/admin/2016/34-77649-s.pdf.
 For more on the SEC’s scrutiny of pre-IPO companies and related issues, see SEC Speech, Chair Mary Jo White, Keynote Address at the SEC-Rock Center on Corporate Governance Silicon Valley Initiative (Mar. 31, 2016), available at www.sec.gov/news/speech/chair-white-silicon-valley-initiative-3-31-16.html.
 In re Apex Fund Serv. (US), Inc., Admin. Proc. File No. 3-17300 (June 16, 2016), available at www.sec.gov/litigation/admin/2016/ia-4429.pdf; In re Apex Fund Serv. (US), Inc., Admin. Proc. File No. 3-17299 (June 16, 2016), available at www.sec.gov/litigation/admin/2016/ia-4428.pdf.
 SEC Press Release, Owner of Formerly Registered Investment Adviser Settles with SEC Regarding Custody Rule, Compliance Rule, and Form ADV Violations (Apr. 14, 2016), available at www.sec.gov/litigation/admin/2016/34-77625-s.pdf.
 See Compl., SEC v. Valvani et al., 16-cv-4512 (KPF) (S.D.N.Y. June 15, 2016).
 See D. Lim & C. Cumming, SEC Official Puts Broker-Dealer Issue Back on Private Equity’s Radar, Wall St. J. (June 7, 2016).
 SEC Press Release, SEC Charges Former Executive of Massachusetts-Based State Street Corporation with Defrauding Investors (May 13, 2016), available at www.sec.gov/litigation/litreleases/2016/lr23540.htm.
 For a critique of the case, see D. Rosenfeld, Phil Mickelson and the SEC’s Legal Bogey, Wall St. J. (June 16, 2016).
 SEC Press Release, SEC Charges Five Individuals With Insider Trading in Stock of E-Commerce Company Prior to Acquisition by eBay (Mar. 1, 2016), available at www.sec.gov/litigation/admin/2016/34-77257-s.pdf.
 Lit. Rel. No. 23492, Former Microsoft Finance Manager Agrees to Settle Insider Trading Charges (Mar. 18, 2006), available at www.sec.gov/litigation/litreleases/2016/lr23492.htm.
 United States v. Newman, 136 S. Ct. 242 (2015) (denying petition for certiorari).
 SEC v. Payton, 97 F. Supp. 3d 558 (S.D.N.Y. 2015).
 SEC Press Release, SEC Obtains Jury Verdict in its Favor Against Former Brokers on Insider Trading Charges (Mar. 2, 2016), available at www.sec.gov/litigation/litreleases/2016/lr23478.htm.
 United States v. Salman, 792 F.3d 1087 (9th Cir. 2015).
 A. Viswanatha & B. Kendall, Supreme Court Takes Up Case That Tests Limits on Insider-Trading Prosecutions, Wall St. J. (Jan. 19, 2016).
 Lit. Rel. No. 23447, Rhode Island Federal Court Denies Alleged Insider Trading Defendants’ Motion to Dismiss (Jan. 20, 2016), available at www.sec.gov/litigation/litreleases/2016/lr23447.htm.
 SEC v. Andrade, No. 15-cv-231, 2016 WL 199423, at *5 (D.R.I. Jan. 15, 2016).
 SEC Press Release, SEC Obtains Court Order to Halt Fraudulent Bond Offering by City of Harvey, Ill. (June 25, 2014), available at www.sec.gov/News/PressRelease/Detail/PressRelease/1370542163027.
 See SEC Investor Alert: Investment Scams Exploit Immigrant Investor Program (Oct. 9, 2013), available at investor.gov/news-alerts/investor-alerts/investor-alert-investment-scams-exploit-immigrant-investor-program.
 D. Michaels, SEC Vacates Order Allowing Rattner to Return to Wall Street, Wall St. J. (Apr. 29, 2016).
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