Articles Posted in Investment litigation

Last September Deputy Attorney General Sally Yates authored a six point Memorandum that identified how the Department of Justice would more effectively go after individuals responsible for corporate wrongdoing. The theory behind the new found emphasis on going after individuals being that corporations only act through individuals. Please click here for a detailed entry I wrote last year on this blog about the Yates Memo.

From an officer or director’s point of view in light of the Yates Memo, they need to take a critical review of the indemnity provisions that are currently in place. By this I mean, what is their employer’s obligations to them if the officers, directors or even high level employees are accused of corporate wrongdoing by either an outside entity like the Justice Department, a disgruntled shareholder in the form of a derivative lawsuit, or perhaps even an internal company investigation? Hiring an independent lawyer to protect your interest in any of these situations is expensive so it is better if the company will pay your legal expenses and even better if your company will advance your legal expenses. Click here for a blog entry I wrote two months ago that explains why it is important to have your own lawyer represent you during these investigations.

To determine what your company will or will not indemnify requires a review of the company’s by-laws. Additional places indemnity provisions can be found are in an employment agreement and not surprisingly, an indemnity agreement. The best protection for an officer or director is actually to have a separate indemnity agreement. Too often I see my clients come to me with their problems but say, “I am not worried, I have indemnification. Look at the by-laws I brought.” Don’t get me wrong, this is a good start, but that is all it is. Do the by-laws require indemnification or is it permissive and require a vote of the board of directors? Even if it is required, are legal fees advanced or only paid after you are found not to have violated your fiduciary duties? Even if the by-laws state it is required and legal fees are to be advanced, what is the process for advancing legal fees? Will the company and its insurance carrier be able to hide behind a convoluted process to delay payments? Does the employer have the ability to restrict your choice of counsel? As you can see there are a myriad of issues even when it seems clear. Even if you have D&O Insurance, keep in mind that the carrier’s policy has exclusions. For example, a typical D&O policy will not cover attorneys’ fee in an internal corporate investigation. Also, D&O policies change year to year as companies are always shopping for better prices so what coverage you have in year one may not be what you have in year two and beyond. However, a well drafted indemnity agreement will require the company to cover all expenses, including legal, incurred in connection with your position as an officer or director of the company to the fullest extent permitted by law and will not change in scope from year to year. These are big differences.

Last month a friend reached out and in passing told me things were going great with the technology he was developing. He also mentioned that he was in the process of raising $5M in exchange for an equity interest in his company. “Great”, I said and casually asked if he had filed anything with the Securities and Exchange Commission (SEC). My friend told me, “No, this is a private placement so I don’t need to register.” I then asked him how he found the investor. The response- “I used a consultant and he gets a small percentage of the money raised.”

This short conversation raises two of the most common mistakes made by early stage companies when they try and raise money. First, a company may not offer or sell its securities to third parties unless the securities have first been registered with both the SEC or there is an exemption from registration that applies. If you don’t make the required filings, you are exposing yourself to serious consequences that include not only an investor’s right to rescission (get their money back) but also fines, penalties and criminal actions against you on an individual basis. Most start-up or early stage companies can avoid this by making the appropriate filing under Section 4(2) of the Securities Act of 1993 and the corresponding safe harbor provisions under Regulation D. There are also corresponding state law security filings too under state “Blue Sky” laws. The point here is that the security laws are complicated and you should not play “security lawyer.”

The second problem mentioned in the scenario described above is that my friend paid a finders’ fee to an unregistered broker-dealer. If the “consultant” was a registered broker-dealer and my friend otherwise made the appropriate Reg D filings he would have been fine. However, by providing compensation to an unregistered broker-dealer, my friend was also violating Section 29 of the Exchange Act which also provides for among other things, the right of rescission. Paying finders’ fees to unregistered broker-dealers has been a recent hot topic for the SEC and the Reg D form filing was updated in 2008 to specifically request information directly to this point (See Item 12 of Form D).

Bank of New York Mellon recently learned the hard way that doing a favor for a client can run afoul of the Foreign Corrupt Practices Act (“FCPA”). How hard was the lesson? The SEC entered an Order that imposed, among other sanctions, a 14.8 million dollar fine merely for the bank hiring three interns who were relatives of foreign officials. In a nut shell, two unnamed officials of a foreign wealth fund put pressure on BNY Mellon to hire three interns who were not otherwise qualified for the BNY Mellon intern program. The bank understood that if they failed to hire these interns, the fund’s investments with the bank would be at risk. It apparently did not matter that the interns did not otherwise meet the requirements for the internship or that they were paid more than the other more qualified interns.

While this may be common practice stateside to grant a favor to a valuable customer by employing his son or daughter, to do so when a foreign official is involved violates the FCPA. The FCPA does not allow a company to influence a foreign official by giving the official “anything of value”. Value is broadly defined and includes cash, gifts, favors and apparently, internships too. While at first blush, this may seem to be a “small favor”. However, the FCPA does not distinguish between “small” or “large” favors only that anything of value were given. In addition, the broadly written FCPA covers any “department, agency or instrumentality” of a foreign government. The foreign wealth fund identified above fell under the “agency or instrumentality” rubric because it was controlled by a foreign government notwithstanding that it operated like any other investment company.

Once again this shows the importance that it is not enough just to have Code of Conduct Policy or an Anti-Corruption Policy without the proper training of the right people in your organization. Training needs to focus not only on the basics but also on the hidden dangers. For example, do changes to the employment application process need to be made? Should an applicant certify that he or she has not been employed as a foreign official or that they do not have a relative or a close personal friend who is a foreign official? If the answer to the foregoing is yes, a strong anti-corruption policy will flag the applicant for further in house review (or legal department) to make the correct determination. This is not a question of discrimination against certain applicants but rather that the correct questions or sensitivities are being looked into so your company does not run afoul of the FCPA. In any event, the point is that your employees need to be trained to look between the trees and make the right determinations when a more nuanced review is needed. The cost of failing to do this is too high and the SEC is bringing the heat.

The Securities and Exchange Commission reported its first enforcement action earlier this month against a company that inserted restrictive language in an employee confidentiality agreement to impede the whistleblower reporting process. In this action, the SEC charged that engineering firm KBR, Inc. violated whistleblower protection rule 21F-17 under the Dodd-Frank Act. (Click here for Order).

The SEC uncovered certain employees who were subject to the internal investigation process were required to sign confidentiality agreements. Among other things, the agreements included language that required the employee to first discuss what they were going to say to the SEC with in-house counsel and that violation of the confidentiality agreement could result in termination of employment.

As a result of this agreement, the SEC imposed a relatively modest fine of only $130,000. The Director of Enforcement for the SEC stated that, “By requiring its employees and former employees to sign confidentiality agreements imposing pre-notification requirements before contacting the SEC, KBR potentially discouraged employees from reporting securities violations to us. SEC rules prohibit employers from taking measures through confidentiality, employment, severance, or other type of agreements that may silence potential whistleblowers before they can reach out to the SEC. We will vigorously enforce this provision.”
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On November 13, 2014 the New Jersey Supreme Court added New Jersey to the growing number of states that have established complex business litigation programs. Effective January 1, 2015, designated judges in each county will provide individualized case management to complex commercial and construction cases that meet the required criteria. The Supreme Court of New Jersey will designate the specific judge who will participate in the program and these judges will receive extensive specialized training in areas that are specific to business litigation.

Attorneys will self-designate their case for this program on the civil case information statement or they may move for inclusion or removal from this program depending on what opposing counsel may or may have not selected. Case will have a minimum $200,000 threshold but in certain circumstances a case may be included in the program due to the complex nature of issues even if the amount in controversy is less than $200,000.

The result of the program will be a win for all parties involved. Consistency will be developed as fewer judges will be ruling on complex commercial disputes. This will help the attorneys provide better cost benefit advice to their client based upon what they can expect at trial.

Judges will benefit as well as they will gain more experience in handling complex business disputes and gain experience and insight into what works and does not work from the point of view from the bench. For example, the judges will see what impact their discovery ruling has at the trial stage and whether they would have liked more information on a particular topic. Now the judges will see what impact their discovery ruling has at trial. In the past, a discovery judge might limit an area of inquiry, but at trial you are faced with a different judge looking down at you with a perplexed look wondering why you did not develop this through further discovery.
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The SEC’s Office of the Whistleblower (OWB) awarded individuals over $14 million in 2013 for their “significant and original contributions” to successful enforcement of the securities laws. The OWB is now in its 3rd full year and the number of tips and complaints is trending upward. OWB reports that it received 3,001 tips and complaint in 2012 and 3,238 in 2013. These numbers are certain to increase as the OWB continually expands the whistleblower laws.

For example, in July 2013, a new pilot program was put into place that protected federal grant workers from whistleblower retaliation. In a nutshell, the new program is designed to protect an employee from employment retaliation for reporting mismanagement of a federal grant or contract funding. An employee who claims to have been retaliated against must file a claim with the Inspector General of the agency involved. If no retaliation is found, the employee can then file a complaint in federal court. If successful, in addition to reinstatement and back pay, attorneys’ fees and costs will also be awarded
Last month I discussed the new path the Securities and Exchange Commission was embarking upon in its efforts to enforce the securities laws from the outside in with the use of deferred prosecution agreements. I noted this was a philosophical change made from the highest levels of the SEC to pursue companies that violate the securities law by targeting employees of suspected target companies. The questions you need to ask yourself as an employee of a company that is involved in fraud are; do I wait until the government agency contacts me as part of its investigation, or do I contact the government agency when I have knowledge of my employer’s widespread fraud? By contacting the government first, you may be entitled to a piece of the substantial awards discussed above. In addition, by taking preemptive action you can protect yourself from being brought down by fellow employees who allege you were part of the fraud.
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Late last year the Securities and Exchange Commission announced that it had entered into its first deferred prosecution agreement (DPA) with an individual who worked in an administrative capacity at a large hedge fund. The DPA allowed the SEC to successfully go after hedge fund manager Berton Hochfield who reportedly stole more than 1.5 million from his hedge fund and overstated the fund’s performance to investors.

A deferred prosecution agreement is a voluntary agreement between an individual and a government agency, in this case the SEC, where the agency will agree to lesser charge in exchange for the individual’s cooperation in connection with the investigation. In the Hochfield case, Scott Herckis voluntarily came to the SEC with concerns over certain accounting irregularities involving Hochfield’s hedge fund, Heppelwhite Fund, LP. Herckis produced a substantial number of documents and described in detail to the SEC how Hochfield perpetrated his fraud. Based upon the information Herckis provided, the SEC was able to take emergency action and freeze the fund’s assets within weeks of Herckis reaching out to the SEC. While Herckis did not get off “scot free” for his participation in the fraud scheme, he did receive a substantially reduced penalty. For example, instead of being unable to be a hedge fund administer for the remainder of his life, Herckis was only prohibited from being a fund administrator for 5 years. Herckis also had to disgorge the fees (approximately $50,000) he received in connection with the fraud.

This DPA is significant because it seems to support new SEC Chair Mary Jo White’s earlier statement that the SEC is going to strongly pursue individuals on the periphery to build its case against greedy insiders and their business entities. By adopting this outside in approach and offering DPAs to periphery individuals, the SEC is placing a significant carrot in front of those who were part of an overall fraud scheme but perhaps feel trapped and want out but do not know how to safely do so.
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