Are the Circuits A-Splitting? The Ninth Circuit Declines to Follow the Second Circuit's Insider Trading Decision in U.S. v. Newman
Why it matters: On July 6, 2015, the Ninth Circuit in U.S. v. Salman declined to adopt a narrow interpretation, arguably set by the Second Circuit in U.S. v. Newman in 2014, of the "personal benefit" element of insider trading cases. The opinion was written by none other than District Court Judge Jed S. Rakoff of the Southern District of New York, sitting by designation. In its cert petition to the Supreme Court in Newman filed on July 30, 2015, the DOJ cited to the circuit split created by the Ninth Circuit's decision in Salman to justify the Supreme Court's review.
Detailed discussion: In U.S. v. Salman, the defendant-appellant Bassam Yacoub Salman (Salman) appealed his insider trading conviction following federal jury trial to the Ninth Circuit, arguing that the evidence the government introduced at trial was insufficient to sustain his conviction under the narrow "personal benefit" standard recently announced by the Second Circuit in U.S. v. Newman, which Salman urged the Ninth Circuit to adopt. The Ninth Circuit, via an opinion written by Manhattan District Court Judge Jed S. Rakoff sitting by designation, respectively declined and upheld Salman's conviction.
The Salman case involved a complicated insider trading scheme involving members of defendant Salman's extended family. At his federal jury trial, the government introduced facts that showed that Salman had received insider information involving upcoming mergers and acquisitions of Citigroup clients from his brother-in-law (via marriage to his sister) Michael Kara (Kara Brother #2). Kara Brother #2 had learned the information from his brother, Mahar Kara (Kara Brother #1), who worked in Citigroup's healthcare investment banking group. Salman then shared the insider information he learned from Kara Brother #2 with the husband of his wife's sister, with whom he split the illicit profits. Of particular relevance on appeal was evidence presented by the government at trial that showed that Salman was "well aware" both that Kara Brother #1 was the source of the insider information and that Kara Brother #1 and Kara Brother #2 shared an extremely "close fraternal relationship" that was "mutually beneficial."
In the appeals period following Salman's conviction, the Second Circuit handed down the Newman opinion, which vacated the insider trading convictions of two downstream tippees on the grounds that the government failed to prove that the tippees knew whether the original insider tippers derived a "tangible personal benefit" from disclosing the information. After the Second Circuit sitting en banc denied the government's petition for rehearing in Newman in 2015, Salman filed a brief with the Ninth Circuit arguing that, if you applied the Newman standard to his case, the information the government presented was insufficient because it failed to show that Kara Brother #1 disclosed the information to Kara Brother #2 in exchange for a tangible personal benefit; that is, a financial benefit, and that Salman knew of such benefit.
Judge Rakoff began his analysis by pointing out that the "personal benefit" requirement for insider trading liability derives from the U.S. Supreme Court's 1983 decision in Dirks v. SEC, which held that "the test is whether the insider personally will benefit, directly or indirectly, from his disclosure … for in that case the insider is breaching his fiduciary duty to the company's shareholders not to exploit company information for his personal benefit." Moreover, Judge Rakoff noted under Dirks that "a tippee is equally liable if 'the tippee knows or should know that there has been [such] a breach,' … i.e., knows of the personal benefit." Of particular importance to Judge Rakoff, the Court in Dirks defined "personal benefit" to include circumstances "when an insider makes a gift of confidential information to a trading relative or friend." Judge Rakoff found that "this last-quoted holding of Dirks governs the case" because Kara Brother #1's disclosure of confidential information to Kara Brother #2, "knowing that he intended to trade on it, was precisely the 'gift of confidential information to a trading relative' that Dirks envisioned." Thus, "there can be no question that, under Dirks, the evidence was sufficient for the jury to find that [Kara Brother #1] disclosed the information in breach of his fiduciary duties and that Salman knew as much."
After determining that the Dirks case was dispositive, Judge Rakoff turned his attention to the Second Circuit's decision in Newman, which narrowed the definition of "personal benefit," and Salman's argument that the Ninth Circuit should adopt it as Salman defined it, making it clear up front that "[o]f course, Newman is not binding on us, and our own reading of Dirks is guided by the clearly applicable language" regarding a "gift of confidential information to a trading relative" constituting sufficient evidence of a personal benefit. Judge Rakoff proceeded to address Newman head on, however, because "we would not lightly ignore the most recent ruling of our sister circuit in an area of law that it has frequently encountered."
Judge Rakoff began by discussing the facts of the Newman case, and its holding in overturning the insider trading convictions of the two downstream tippees in that case because "'the Government presented absolutely no evidence that [the two tippees] knew that they were trading on information obtained from insiders, or that those insiders received any benefit in exchange for such disclosures.'" [Emphasis added.] In Newman, the Second Circuit looked at the casual friendships between the original insiders and the first-level tippees and said that such "evidence of a friendship or familial relationship between tipper and tippee, standing alone, is insufficient to demonstrate that the tipper received a benefit" and that a "personal benefit" including "'at least a potential gain of a pecuniary or similarly valuable nature" is required. Thus, Salman argued, to the extent that the government failed to show evidence that Kara Brother #1 received any such "tangible" "pecuniary or similarly valuable" benefit in exchange for the inside information from Kara Brother #2, and that Salman personally knew of such benefit, Newman would require his conviction be overturned.
Judge Rakoff rejected Salman's argument, stating that "[t]o the extent Newman can be read to go so far, we decline to follow it. Doing so would require us to depart from the clear holding of Dirks that the element of breach of fiduciary duty is met where an 'insider makes a gift of confidential information to a trading relative or friend.'" Judge Rakoff concluded that, if Salman's reading of Newman were followed and the evidence against Salman was found to be insufficient, "then a corporate insider or other person in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return. Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish breach of the fiduciary duty element of insider trading."
Is this decision sufficient to establish a split in the Second and Ninth Circuits or will Judge Rakoff's careful language allow both to coexist? On July 30, 2015, the DOJ filed a cert petition in Newman citing to this split in the circuits (it also cited to a Seventh Circuit civil case) to justify the Supreme Court's review. We shall report back on whether it is successful.
See here to read the decision in U.S. v. Bassam Yacoub Salman, No. 14-10204 (9th Cir. 2015).
See here to read the DOJ's Petition for Writ of Certiorari in U.S. v. Chiasson filed on July 30, 2015.
For more on this matter, see U.S. v. Todd Newman et al., 773 F.3d 438 (2d Cir. 2014), and Dirks v. S.E.C., 463 U.S. 646 (1983).
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Tuomey Healthcare $237 Million Verdict Upheld: Advice of Counsel Means ALL Counsel
Why it matters: On July 2, 2015, the Fourth Circuit affirmed a federal jury verdict of over $237 million against Tuomey Healthcare System (Tuomey), the largest judgment ever imposed against a nonprofit community hospital for violations of the Stark Law and False Claims Act in connection with its physician contracts. The opinion focused on Tuomey's assertion of the advice-of-counsel defense, advice received from multiple healthcare attorneys, and the trial court's ultimately damaging admission of testimony from one healthcare attorney who noted numerous "red flags" of illegality regarding the contracts.
Detailed discussion: Commencing around 2000, area doctors who had previously performed outpatient surgery at Tuomey began performing the procedures at their own offices or at off-site surgery centers, resulting in a substantial loss of facility fee revenue to Tuomey. In an attempt to stem the loss, Tuomey decided to negotiate part-time employment contracts with a number of local physicians to bring them back to Tuomey's outpatient surgical facility. Tuomey was "well aware" of the Stark Law restrictions in connection with the proposed employment contracts and, to that end, sought the advice of its longtime legal firm, Nexsen Pruet, in 2003. Nexsen Pruet in turn engaged Cejka Consulting, a national consulting firm that specializes in matters involving physician compensation, which provided Tuomey and Nexsen Pruet with "an opinion concerning the commercial reasonableness and fair market value of the contracts." Tuomey also obtained an opinion on the contracts vis à vis the Stark Law from Richard Kusserow (Kusserow), an attorney and former Inspector General for the U.S. Dept. of Health and Human Services (HSS).
Tuomey's part-time employment contracts, as drafted by Nexsen Pruet, provided for, in relevant part, (1) a 10-year term, during which the physicians could maintain their private practices but were required to exclusively use Tuomey's surgery center for outpatient procedures; (2) physician compensation consisting of an annual guaranteed base salary, "productivity bonus" and "incentive bonus," plus healthcare and covered medical malpractice liability insurance, employment taxes and billing and collection costs; (3) restrictions on the physician having an ownership interest in other outpatient surgery centers in Sumter; and (4) a "non-compete" clause preventing the physicians from performing outpatient surgical procedures within a 30-mile radius of Tuomey for two years after the expiration of the contract.
Tuomey entered into these part-time employment agreements with 19 area physicians; however, one local physician, Michael Drakeford (Drakeford), declined to sign because he believed that the contracts violated the Stark Law. In order to address Drakeford's concerns, in September 2005 Tuomey and Drakeford jointly sought the advice of Kevin McAnaney (McAnaney), a private attorney with Stark Law expertise who, while formerly serving as the Chief of the Industry Guidance Branch of the HSS Office of Counsel to the Inspector General, wrote a "substantial portion" of the Stark Law's implementing regulations. After a review of the employment contracts, McAnaney advised Tuomey and Drakeford that they contained "significant red flags" under the Stark Law in that, among other things, they compensated physicians in excess of the fair market value of their services and their collections and warned that the government would find this an "easy case to prosecute." After receiving McAnaney's negative advice, Tuomey terminated his representation, continued to use the part-time employment contracts as drafted and sought and received yet another positive opinion from Steve Pratt (Pratt), an attorney at the healthcare law firm of Hall Render, although he was not given McAnaney's negative views.
Drakeford ultimately sued Tuomey in federal district court in South Carolina under the qui tam provisions of the False Claims Act (FCA), alleging that, as the part-time employment contracts violated the Stark Law, Tuomey had been knowingly submitting false claims for payment to Medicare in violation of the FCA. The government intervened in the qui tam action and filed additional claims for equitable relief. Two federal jury trials ensued. At the first jury trial, the judge excluded McAnaney's testimony and opinions after Tuomey successfully objected both on duty of loyalty grounds and pursuant to Federal Rule of Evidence 408 (Tuomey claimed that McAnaney was helping the parties settle a dispute). Tuomey also prevented admission of deposition testimony of Gregg Martin (Martin), Tuomey's SVP and CEO, that contained Martin's recollections of a conversation he had with Tuomey's counsel regarding McAnaney's advice. With the testimony and opinions of both McAnaney and Martin excluded, the first jury returned a verdict finding that, while Tuomey had violated the Stark Law with its employment contracts, it had not "knowingly" violated the FCA, since it had relied on advice of counsel.
The district court judge then granted the government's motion for a new trial, agreeing with the government that he had "committed a substantial error" in excluding Martin's deposition testimony (the judge was silent as to his exclusion of McAnaney's testimony). While the government had asked for a new trial based solely on the "knowledge" element of the FCA claim, the judge granted a new trial as to the entirety of the claim, including the Stark Law violation. Notwithstanding this, the judge also granted the government's motion for equitable relief as to the jury's verdict on the Stark Law violation and ordered Tuomey to pay almost $45 million in damages plus pre- and post-judgment interest. Tuomey appealed to the Fourth Circuit, which vacated the $45 million judgment and remanded the case to the district court for a new trial as to all claims.
While the case was on appeal to the Fourth Circuit, the initial presiding district court judge passed away. At the second trial, the new trial judge admitted McAnaney's testimony as well as Martin's deposition testimony. The second jury found that Tuomey violated the Stark Law and "knowingly" violated the FCA. The judge trebled the actual damages and assessed an additional civil penalty as required by the FCA, resulting in a total judgment against Tuomey of $237,454,195.
Tuomey again appealed to the Fourth Circuit, which affirmed the judgment in its recent opinion. The Court began its analysis with a general review of the Stark Law before addressing the issues on appeal. We focus here on two of the issues: (1) whether, after the first trial, the district court erred in ordering a new trial on the FCA claim and (2) whether, after the second trial, the district court erred in denying Tuomey's motion for judgment as a matter of law that a reasonable jury would not have found Tuomey to have "knowingly" violated the FCA. With respect to the first issue, the Court affirmed the district court's order granting a new trial on the FCA claim based on what it considered to be the "glaring error" of the exclusion of McAnaney's testimony at the first trial. The Court found that the government had been prejudiced at the first trial by the exclusion of McAnaney's testimony because "[t]o make its case that Tuomey 'knowingly' submitted false claims under the FCA, the government needed to show that Tuomey knew that there was a substantial risk that the contracts violated the Stark Law, and was nonetheless deliberately ignorant of, or recklessly disregarded that risk. In our view, McAnaney's testimony was a relevant, and indeed essential, component of the government's evidence on that element." The Court noted that the district court had presided over two trials in the case "with strikingly disparate results," with the main difference between the two being McAnaney's testimony: "Coincidence? We think not. Rather, we believe that these results bespeak the importance of what the jury in the first trial was not allowed to consider." The Court reviewed the substance of McAnaney's testimony and found its importance to be "self-evident," concluding that "it is difficult to imagine any more probative and compelling evidence regarding Tuomey's intent than the testimony of a lawyer hired by Tuomey, who was an undisputed subject matter expert on the intricacies of the Stark Law, and who warned Tuomey in graphic detail of the thin legal ice on which it was treading with respect to the employment contracts." In this regard, the Court noted that Tuomey had waived the attorney-client privilege with respect to its communications with McAnaney when it asserted the advice-of-counsel defense to the FCA claim.
The Court next reviewed Tuomey's argument that a reasonable jury would not find that Tuomey "knowingly" violated the FCA because it relied in good faith on the advice of counsel. After reiterating that the term "knowingly" under the FCA means actual knowledge, deliberate ignorance or reckless disregard of the truth, the Court found that there was "ample support" for the jury's verdict as to Tuomey's intent because "the record is replete with evidence indicating that Tuomey shopped for legal opinions approving the employment contracts, while ignoring negative assessments." The Court agreed with the district court's conclusion that a reasonable jury could have found that Tuomey possessed the "'requisite scienter once it determined to disregard McAnaney's remarks,'" stating that "[a] reasonable jury could indeed be troubled by Tuomey's seeming inaction in the face of McAnaney's warnings, particularly given Tuomey's aggressive efforts to avoid hearing precisely what McAnaney had to say regarding the contracts."
The Court acknowledged that "a defendant may avoid liability under the FCA if it can show that it acted in good faith on the advice of counsel" but made clear that consultation with an attorney does not confer automatic immunity and that the defendant has to show the "'full disclosure of all pertinent facts to [counsel] and … good faith reliance on [counsel's] advice.'" As to the favorable opinions Tuomey had obtained from Nexsen Pruet, Kusserow and Pratt, the Court found that Tuomey did not provide Kusserow or Pratt with the "full and accurate" information necessary to support their opinions, and Tuomey failed to disclose to Pratt the negative advice it had received from McAnaney. The Court stated that, for a reasonable jury to find that Tuomey relied in good faith on the advice of counsel, "the jury was entitled to consider all the advice given to it by any source," i.e., McAnaney's negative advice had to be considered as well. As Judge Wynn said in his concurring opinion with respect to the first jury trial, "[h]aving put the advice it got from its lawyers squarely at issue, Tuomey should not have been permitted to cherry-pick which advice of counsel the jury was permitted to hear. Instead, the jury should have been allowed to consider all the advice of all Tuomey's counsel – including McAnaney … [t]he record makes clear that, whatever else McAnaney's assessment was, it was also advice of counsel."
The Court therefore agreed with the district court that "a reasonable jury could have concluded that Tuomey was, after September 2005, no longer acting in good faith reliance on the advice of its counsel," and concluded that "we have no cause to upset the jury's reasoned verdict that Tuomey violated the FCA."
Judge Wynn concluded his concurring opinion by stating "[t]his case is troubling. It seems as if, even for well-intentioned health care providers, the Stark Law has become a booby trap rigged with strict liability and potentially ruinous exposure—especially when coupled with the False Claims Act. Yet, the district court did not abuse its discretion when it granted a new trial and the jury did not act irrationally when it determined that Tuomey violated both the Stark Law and the False Claims Act. Accordingly, I must concur in the outcome reached by the majority." For its part, the Fourth Circuit majority was sympathetic to Judge Wynn's assessment, and seemed to echo his reluctant affirmation of the jury verdict against Tuomey, stating that "we do not discount the concerns raised by our concurring colleague regarding the result in this case. But having found no cause to upset the jury's verdict in this case and no constitutional error, it is for Congress to consider whether changes to the Stark Law's reach are in order."
See here to read the Fourth Circuit opinion in United States ex rel. Michael K. Drakeford, M.D. v. Tuomey, dba Tuomey Healthcare System, Inc., No. 13-2219 (Fourth Cir. 2015).
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When Is a Whistleblower a Whistleblower? Three Recent Federal Court Cases Tackle the Question
Why it matters: With the influx of potentially lucrative "whistleblower" cases being brought by individuals reporting perceived corporate wrongdoing, three recent federal court cases provide clarification about exactly who qualifies as a "whistleblower" under the False Claims Act, the Health Insurance Portability and Accountability Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act, respectively.
Detailed discussion: Three recent federal court cases provide clarification of who will qualify as a "whistleblower" under the False Claims Act (FCA), the Health Insurance Portability and Accountability Act of 1996 (HIPAA) and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), respectively.
FCA: On July 7, 2015, the Ninth Circuit, sitting en banc in U.S. ex rel. Steven J. Hartpence and Geraldine Godecke v. Kinetic Concepts, Inc.; KCI-USA, Inc., reversed the district court's dismissal of the consolidated qui tam suits brought under the FCA which had alleged that the Relators' former employer had submitted fraudulent claims for reimbursement to Medicare. In the case, Relators Steven J. Hartpence and Geraldine Godecke had each informed the government about their former employer's alleged Medicare fraud after the fraud had already been publicly disclosed, and then had proceeded to file separate qui tam complaints six months apart in district court (the court also made a "first-to-file" ruling not addressed here). Relying on the precedent established by the Ninth Circuit in Wang ex rel. United States v. FMC Corp., 975 F.2d 1412, 1418 (9th Cir. 1992), the district court had dismissed the complaints, holding that neither Relator was an "original source" so as to constitute a "whistleblower" under the FCA because neither had been involved in the public disclosure of the fraud as Wang would require. The Ninth Circuit en banc panel framed the issue by asking "[i]f a whistleblower informs the government that it has been bilked by a provider of goods and services, and that scheme is unmasked to the public, under what conditions can the same whistleblower recover part of what the guilty provider is forced to reimburse the government?" The court first noted that a qui tam suit is barred under the FCA if there has been a public disclosure of the fraud, unless the qui tam "relator" qualifies as an "original source" of the information. The court then held that there are "two, and only two," requirements for a relator to constitute an "original source" under the FCA: "(1) Before filing the action, the whistleblower must voluntarily inform the government of the facts which underlie the allegations of the complaint; and (2) the whistleblower must have direct and independent knowledge of the allegations underlying the complaint." Specifically overruling Wang, the court held that "it does not matter whether [the relator] also played a role in the public disclosure of the allegations that are part of the suit." The court reversed and remanded the cases to the district court to consider whether the Relators qualified as "original sources" under the two-part test announced in the opinion.
HIPAA: On July 1, 2015, District Court Judge J. Leon Holmes for the Eastern District of Arkansas ruled in the case of Howard v. Arkansas Children's Hospital that Pam and Eben Howard (Relators) constituted whistleblowers under the retaliatory discharge provisions of HIPAA and thus did not violate HIPAA when they shared patients' personal health information in their possession with their attorney. The Relators claimed in their lawsuit against the hospital that they were terminated from their management positions after they expressed concern about the manner in which the hospital was billing the federal government (the Relators had also alleged retaliatory discharge under the FCA, not addressed here). The facts of the case show that, during the course of their employment, the Relators acquired a large amount of personal health information regarding the hospital's patients that they kept after they were terminated. In the course of discovery, the Relators disclosed to the hospital that they were in possession of the personal health information and had shared it with their attorney. The hospital charged that the Relators had violated HIPAA by both retaining the personal health information after they were terminated and sharing it with their attorney, but the Relators claimed that they fell within the HIPAA whistleblower exception. The hospital filed a motion for summary judgment on numerous grounds, and as part of the filing asked the court for a determination that the Relators did not constitute whistleblowers under HIPAA. Judge Holmes declined to do so. The judge first quoted HIPAA's retaliatory discharge provision, which states in relevant part that "[a] covered entity is not considered to have violated the requirements of this subpart if a member of its workforce … discloses protected health information, provided that … [t]he workforce member … believes in good faith that the covered entity has engaged in conduct that is unlawful … and … [t]he disclosure is to … [a]n attorney retained by or on behalf of the workforce member … for the purpose of determining the legal options of the workforce member." Judge Holmes next established that (1) the hospital was a "covered entity" for purposes of HIPAA, (2) the Relators were members of its workforce before they were terminated and acquired the personal health information in the course of their duties, (3) the Relators believed in good faith that the hospital had behaved unlawfully, and (4) the Relators shared the information with their attorney for the purposes of determining their legal options with regard to their concerns. The judge concluded that the Relators had thus "met their burden of showing that they qualify as whistleblowers under the HIPAA regulations."
Dodd-Frank: In a ruling on June 17, 2015, in Wiggins v. ING United States, Inc. et al., District Court Judge Janet C. Hall of the District of Connecticut followed the Fifth Circuit's narrow construction of who constitutes a "whistleblower" under Dodd-Frank and ruled that the Relator failed to state a cause of action under that statute because she did not specifically provide information to the SEC. In the case, Relator Eva Wiggins (Wiggins) had filed a complaint against her employer ING alleging that ING had fired her in retaliation for alerting her supervisors about wrongdoing she had witnessed during the course of her employment and raising claims invoking, among other things, the retaliatory discharge provisions under both Dodd-Frank and the Sarbanes-Oxley Act of 2002 ("SOX"). ING had filed a motion to stay or dismiss pending arbitration proceedings (to which, it argued with mixed success, she was bound) and, in the course of ruling on the motion, the court addressed ING's argument that Wiggins was not a "whistleblower" as defined in Dodd-Frank and thus was unable to state a claim under that statute. The court began its analysis by quoting the relevant definitional provision of Dodd-Frank: "The term 'whistleblower' means any individual who provides … information relating to a violation of the securities laws to the [Securities and Exchange] Commission." Wiggins admitted that, while she reported suspected violations to her supervisors, she did not specifically provide information to the SEC; however, she argued that this was too narrow a reading of the statute and would serve to discourage, not incentivize, the reporting of corporate wrongdoing in defeat of the statutory purpose (the SEC filed an amicus brief to this effect as well). Judge Hall acknowledged that there was a split among the district courts that had considered this question; however, she stated that a "better reading" of the statute and its implications can be found in the only appellate case to date that had addressed the issue, the 2013 Fifth Circuit case of Asadi v. G.E. Energy (USA), L.L.C., which held the "clear language" on the face of the statute required that the report be made to the SEC. Judge Hall concluded that Wiggins failed to state a cause of action as a whistleblower under Dodd-Frank because "from the clear language used in the statute … Congress did not intend to include someone in Wiggins' position within the protections extended under the Dodd-Frank Act." Noting that Wiggins already had a retaliatory discharge cause of action under SOX as a result of reporting the perceived wrongdoing to her supervisors, "the statutory language indicates that Congress concluded that it is persons who report to the SEC who should receive the further protection of a separate cause of action under Dodd-Frank."
See here to read the July 7, 2015, Ninth Circuit decision in the consolidated cases of United States Ex Rel. Steven J. Hartpence and United States Ex Rel. Geraldine Godecke v. Kinetic Concepts, Inc.; KCI-USA, No. 12-55396 (Ninth Cir. en banc 2015).
See here to read the July 1, 2015, District Court (for the Eastern District of Arkansas) opinion in Pam Howard and Eben Howard ex rel. United States of America v. Arkansas Children's Hospital, Ron Robertson, individually; and Jon Bates, individually, No. 4:13CV00301 JLH.
See here to read the June 17, 2015, District Court (for the District of Connecticut) decision in Wiggins v. ING United States Inc., et al., No. 3:14-cv-1089 (JCH).
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Fantasy Investing Meets Real Life: Sand Hill Exchange Settles With the SEC for the Illegal Offering of Unregistered Security-Based Swaps
Why it matters: On June 17, 2015, the SEC announced that it had reached a settlement with Sand Hill Exchange to resolve charges that it had illegally offered and sold unregistered security-based swap contracts to ineligible retail investors through a form of "fantasy investing" league. The same day, the SEC's Office of Investor Education and Advocacy issued an Investor Alert warning investors to "Beware of Fantasy Stock Trading Websites Offering Real Returns."
Detailed discussion: On June 17, 2015, the SEC announced that it had reached a settlement with San Mateo, California-based unincorporated business Sand Hill Exchange (Sand Hill) and the two individuals who jointly ran it, Gerrit Hall (Hall) and Elaine Ou (Ou), to resolve charges that they had sold unregistered security-based swaps to retail investors who did not meet mandated "eligibility requirements" in violation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). As part of the settlement, and without admitting or denying the SEC's findings, Sand Hill, Hall and Ou agreed to cease and desist their activities and pay the SEC a civil monetary penalty of $20,000. The SEC acknowledged the cooperation of Sand Hill, Hall and Ou in the investigation.
The findings contained in the Order filed simultaneously with the SEC's press release show that Hall and Ou started Sand Hill in August 2014 with the intent to "create a business that would involve valuing private start-up companies," with a special focus on companies operating in Silicon Valley, California. Over the next seven months, Hall and Ou experimented with several "fantasy investment" business models that were variations of "fantasy sports" leagues where "trading" involved valuations of private start-up companies using "credits" issued by Sand Hill. However, starting around mid-February 2015, Hall and Ou began inviting users to "trade" contracts using real money. The findings show that Hall and Ou "fully" understood that they were "buying and selling derivatives linked to the value of private companies" and that they intended to pay users who profited from the contracts they purchased. Under the new business model, "users funded their Sand Hill accounts with either dollars or Bitcoins and then bought and sold contracts that would allow them to profit (or suffer losses) in the future." Hall sent emails to Sand Hill users on February 13, 2015, announcing the new business model and stating "[i]f you ever wanted to profit off an early stage startup, now's your chance. Here's how it works: We list great startups, from seed stage to pre-IPO; You can buy/sell smart contracts on the expected value of the company at liquidation; You can close your position at any time, or hold on until the company exits." One example of a contract that users were able to buy involved the payment of one dollar for every $1 billion of the company's valuation at the time of an IPO or other "liquidity event." The findings show that Hall and Ou did not ask users about their financial holdings or seek to limit Sand Hill to users with a specific threshold of assets, stating on their website that "[w]e accept everybody regardless of accreditation status." The findings also show that, in order to attract users, Hall and Ou routinely exaggerated or outright lied about Sand Hill's trading accomplishments, backing, and legal, auditing, and regulatory approval undertakings on the website, in emails and in Twitter posts.
Ultimately, the findings show that 83 individuals "traded" 2,300 contracts with an aggregate value of $10,000, which provided Sand Hill profits of about $5,400 in dollars and Bitcoins. On March 10, 2015, the Financial Times published an article on its blog about Sand Hill and, two days later on March 12, Hall and Ou received their first inquiry from the SEC. Thereafter, Hall and Ou only accepted money from five new users and cooperated with the SEC's investigation, which the SEC credited as "limiting the scope of their violations." By April 8, 2015, Hall and Ou had ceased Sand Hill operations altogether and refunded all deposits to users.
The SEC found that the Sand Hill contracts were derivative "security-based swaps" regulated by Dodd-Frank because their "payouts were linked to the valuation of private companies at a liquidity event" in the future, such as a merger, initial public offering or dissolution. Sand Hill, Hall and Ou were found to have offered and sold the security-based swap contracts in violation of Dodd-Frank because they were issued without a registration statement or backing of a national exchange to individuals who were not "eligible contract participants," defined in the statute to include individuals who meet stated "sophistication" standards such as monetary thresholds invested (e.g., at least $5-$10 million invested in the market on a discretionary basis).
Also on June 17, 2015, as a "companion piece" to its press release, the SEC's Office of Investor Education and Advocacy issued an Investor Alert warning investors to "Beware of Fantasy Stock Trading Websites Offering Real Returns," which stated its purpose was to "warn investors about fantasy stock trading and other similar websites that may violate federal securities laws designed to protect investors from abuses in the swaps market." The Alert began with the statement that "[y]ou may come across websites that claim to offer you the chance to make money from publicly traded or privately held companies without actually buying stock in those companies. You (as well as the operators of these sites) should be aware that some of these transactions could fall under a type of security known as a 'security-based swap.' Transactions on these websites can implicate both the federal securities and commodities laws. Even when the site presents the transaction as a 'fantasy' trading game or competition, and even when it involves only small amounts of money (sometimes called an 'entry fee'), you should understand these sites may be violating laws designed to protect investors." (Emphasis in original.) The Alert helpfully describes security-based swaps and states that the SEC is in the process of implementing a new regulatory regime for them. The Alert also informs investors that, in order to "trade" these swaps, they need to qualify as "eligible contract participants," which the Alert goes on to define. Last, the Alert highlights the types of "pay-to-play 'fantasy' trading competitions" investors should look out for, and specifically references the SEC's enforcement action against Sand Hill, Hall and Ou.
In its June 17 press release, the SEC emphasized that this is only the beginning of the investigation into these "fantasy trading" sites and their ilk: "The Complex Financial Instruments Unit will continue its scrutiny of the retail market for conduct that may violate the Dodd-Frank Act's swaps provisions, including online competitions creatively monetizing what actually constitute security-based swaps transactions."
See here to read the SEC's 6/17/15 press release titled "SEC Announces Enforcement Action for Illegal Offering of Security-Based Swaps."
See here to read the SEC's Order dated 6/17/15 titled "In the matter of Sand Hill Exchange, Gerrit Hall and Elaine Ou."
See here to read the Investor Alert issued by the SEC's Office of Investor Education and Advocacy titled "Beware of Fantasy Stock Trading Websites Offering Real Returns."
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KKR the First Private Equity Adviser to Be Charged by the SEC With Misallocation of Broken Deal Expenses in Breach of Its Fiduciary Duty
Why it matters: In the first SEC enforcement action of its kind brought against a private equity adviser, on June 29, 2015, the SEC announced that KKR had agreed to pay approximately $30 million (including a $10 million penalty) to settle charges that it had breached its fiduciary duty to the limited partners of its "flagship" private equity limited partnership investment funds by misallocating over $17 million in "broken deal" expenses to them.
Detailed discussion: On June 29, 2015, the SEC announced that it had charged private equity adviser Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in "broken deal" expenses (i.e., diligence, research, travel and other expenses incurred in connection with unsuccessful buyout transactions) to its "flagship" private equity limited partnership investment funds (Funds). KKR was also found to have failed to implement a written compliance policy governing its broken deal expense allocation practices. Without admitting or denying the SEC's factual findings, KKR agreed to the entry of an Order finding it to have breached its fiduciary duty to the Funds in violation of Sections 206(2) and (4) of the Investment Advisors Act of 1940 and related Rule 206(4)-7. To settle the charges, KKR agreed to pay approximately $14 million in disgorgement ($3.26 million was previously refunded to clients) as well as $4.5 million in prejudgment interest and a civil penalty of $10 million.
The press release states that the enforcement action against KKR was the result of an investigation being conducted by the Enforcement Division's Asset Management Division into the private equity industry focusing on whether investors are being unfairly charged with fees and expenses by fund managers. The SEC investigated KKR over a period of six years ending in 2011. The findings in the Order describe KKR as a "private equity firm that specializes in buyout and other transactions." The Order details KKR's complicated structure of investment funds and private equity investment vehicles, but we briefly boil down the SEC's findings relevant to this case here: In addition to the Funds, KKR advises and maintains other investment vehicles that invest with the Funds in buyouts and other transactions, including some that are affiliated with KKR through KKR partner ownership or other structural affiliation (KKR Co-Investors). The findings show that, during the relevant time period, KKR incurred roughly $338 million in broken deal expenses but that, with one limited exception in 2011 (after the implementation of a written compliance policy), none of those expenses were allocated by KKR to the KKR Co-Investors. Instead, the SEC found that KKR misallocated more than $17 million of the broken deal expenses to the Funds without disclosing the fact that it was doing so in its limited partnership agreements or related offering materials. Furthermore, the findings show that KKR did not implement a written compliance policy with respect to the allocation of broken deal expenses until 2011, six years after the start of the SEC's investigation.
SEC Enforcement Division Director Andrew J. Ceresney said in the press release that "[t]his is the first SEC case to charge a private equity adviser with misallocating broken deal expenses. Although KKR raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed." With respect to KKR's failure to have a written compliance program with respect to broken deal expense allocation in place, Marshall S. Sprung, Co-Chief of the SEC's Enforcement Division's Asset Management Unit said "KKR's failure to adopt policies and procedures governing broken deal expense allocation contributed to its breach of fiduciary duty. A robust compliance program helps investment advisers ensure that clients are not disadvantaged and receive full disclosure about how fund expenses are allocated."
See here to read the SEC's press release dated 6/29/15 titled "SEC Charges KKR With Misallocating Broken Deal Expenses."
See here to read the SEC's Order dated 6/29/15 titled "In the Matter of Kohlberg Kravits Roberts & Co. L.P."
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Keeping an Eye Out: Updates and Briefly Noted
Swiss Bank Program: Fourteen more Swiss banks reached resolution with the DOJ under its Swiss Bank Program (first reported on in our April newsletter under "First Swiss Bank Reaches Resolution with the DOJ Under Its Swiss Bank Program"). (7/30/15, 7/23/15, 7/16/15, 7/9/15, 7/2/15, 6/26/15 and 6/19/15)
FCPA highlights: The SEC announced that Mead Johnson Nutrition Company agreed to pay $12 million in disgorgement and penalties to settle charges that its Chinese subsidiary paid bribes to medical professionals at government-owned hospitals to recommend Mead's infant formula to new mother patients (7/28/15). The DOJ announced that Louis Berger International, Inc., entered into a DPA and agreed to pay a $17.1 million criminal penalty to resolve charges that it bribed foreign officials in India, Indonesia, Vietnam and Kuwait to secure government construction management contracts in violation of the FCPA. Two of the company's former executives also pleaded guilty to conspiracy and FCPA charges in connection with the scheme (7/17/15). In what is being billed as the first completed FCPA investigation of 2015, the DOJ announced that Florida-based defense and government contracting company IAP Worldwide Services Inc. entered into an NPA with the government and agreed to pay a $7.1 million penalty to resolve the DOJ's investigation into bribes paid to Kuwaiti officials to secure government contracts in violation of the FCPA. A vice president of the company also pleaded guilty to one count of conspiracy to violate the FCPA (6/16/15). In connection with its announcement of the guilty plea by former PetroTiger co-CEO Joseph Sigelman for conspiring to pay bribes to foreign officials in violation of the FCPA, the DOJ announced that it was declining to prosecute PetroTiger based on its "voluntary disclosure, cooperation, and remediation." (6/15/15).
DOJ seeks forfeiture: In connection with a multicountry telecom corruption probe, the DOJ filed a complaint in Manhattan federal district court seeking forfeiture of $300 million being held by Bank of New York Mellon in Ireland, Luxembourg and Belgium which it claims are the proceeds of an international bribery conspiracy involving two Russian phone companies and a close relative of Uzbekistan's president (7/3/15). The DOJ announced that it filed a complaint in federal district court in Washington, D.C., seeking forfeiture of $34 million in bribe payments to the Republic of Chad's former ambassador to the United States and Canada. The forfeiture amount represents the cash value of shares in a Canadian energy company that the company used to bribe Chad's former ambassador to the United States and Canada in order to influence the award of oil development rights (6/30/15).
Whistleblower news roundup: The SEC announced that medical device manufacturer NuVasive Inc. agreed to pay $13.5 million to settle FCA violations relating to the marketing of medical devices to doctors for use in spine surgeries in a manner not approved by the FDA, thereby causing the doctors to submit false claims to Medicare. Qui tam whistleblower to receive award of $2.2 million (7/30/15). The SEC announced that it was paying $3 million to a whistleblower in a complex fraud case, constituting the third-biggest award under the SEC's whistleblower program that launched in 2011 (7/17/15). A qui tam whistleblower (and former sales rep) in the Endo Pharmaceuticals, Inc., FCA case was awarded $33.6 million, or 24% of the $137 million paid by Endo Pharmaceuticals in 2014, when it entered into a DPA with the DOJ in connection with alleged off-label marketing of Lidoderm pain patch (7/17/15). Colorado-based dialysis services provider DaVita Healthcare Partners, Inc., agreed to pay $450 million to resolve FCA violations relating to the creation of and billing for unnecessary waste in connection with the administration of two dialysis drugs. Two qui tam whistleblowers to split an award of up to $135 million (6/25/15). Florida-based skilled nursing facility Hebrew Homes Health Network, Inc., and its former president/executive director agreed to pay $17 million to resolve FCA violations relating to improper payments to doctors for referrals of Medicare patients requiring skilled nursing care. This is the largest settlement involving alleged violations of the Anti-Kickback Statute by a U.S. skilled nursing facility. Qui tam whistleblower to receive $4.25 million (6/16/15).
Challenges to SEC administrative proceedings: In Tilton v. SEC (first reported on in our April newsletter under "Wherefore Art Thou Due Process? SEC Administrative Hearings Under Attack"), S.D.N.Y. District Court Judge Ronnie Abrams denied plaintiff Tilton's motion for preliminary injunction and dismissed her complaint for lack of subject matter jurisdiction, stating that Tilton's "exclusive avenue of review" is through the SEC administrative process, which must be exhausted before bringing her challenge in federal court. Judge Abrams acknowledged that the district courts in New York and other states have split on this issue, but cited to cases finding lack of subject matter jurisdiction to be "more persuasive." Tilton has filed an appeal to the Second Circuit (6/30/15). The SEC's Enforcement Division filed a rare petition for review with the SEC of Administrative Law Judge James E. Grimes's 6/4/15 decision ruling against it in In the Matter of Robare Group, et al. ALJ Grimes had dismissed all charges in a conflicts of interest case involving failure to disclose custodians' payments to advisers (6/25/15).
Other items of interest: The SEC announced that it had fined Deloitte & Touche approximately $1 million for violating auditor independence rules with respect to the appearance of independence and impartiality. The SEC found that Deloitte & Touche's consulting affiliate maintained a business relationship with a trustee serving on the boards and audit committees of three funds audited by the accounting firm. The trustee and the funds' administrator ALPS Fund Services were also charged with related reporting and compliance violations and agreed to settle the charges (7/1/15). The SEC announced that Goldman Sachs agreed to pay $7 million in penalties to resolve allegations that it violated the market access rule by not having adequate safeguards in place while using new software to prevent the "glitch" that resulted in the firm erroneously sending out approximately 16,000 mispriced option orders in less than an hour on 8/20/13 (6/30/15). The DOJ announced a national Medicare fraud sweep resulting in charges against 243 individuals for approximately $712 million in false billing (6/18/15).
Talks about town: Attorney General Loretta E. Lynch spoke at the DOJ Cybersecurity Symposium (7/21/15). Associate Director of Enforcement for FinCen Stephanie Booker spoke at the 2015 Bank Secrecy Act Conference (6/18/15). Assistant Attorney General Leslie R. Caldwell spoke at the 26th Annual Association of Certified Fraud Examiners Global Fraud Conference (6/15/15).
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