Source: http://pomerantzlawfirm.com/publications/tag/September%2FOctober+2017
Timestamp: 2019-04-22 10:07:11+00:00

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Next term, the Supreme Court has agreed to resolve a split of authority among the federal courts of appeals on whether an employee who blows the whistle on corporate misconduct internally, but has not yet registered a formal complaint with the SEC, is protected by the anti-retaliation provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”).
Section 21F of the Exchange Act, added by Dodd-Frank, directs the SEC to pay awards to individuals who provide information to the SEC that forms the basis of a successful enforcement action, and prohibits employers from retaliating against such whistleblowers for reporting violations of the securities laws. Section 21F defines a “whistleblower” as “any individual who provides . . .information relating to a violation of the securities laws to the Commission . . . ” This definition limits whistleblowers to people who actually provide information to the SEC; but subdivision (iii) of the anti-retaliation provisions protects any employee who makes disclosures to the SEC or makes “disclosures that are required or protected under the Sarbanes-Oxley Act of 2002 [“SOX”], . . . the Securities Exchange Act of 1934 . . . and any other law, rule, or regulation subject to the jurisdiction of the Commission.” So, the question is whether the anti-retaliation provisions apply to people who may not fall within the definition of whistleblowers under the Act.
In 2013, the manager of G.E. Energy in Iraq filed a lawsuit against the company pursuant to the antiretaliation provisions of Dodd-Frank. He alleged that he was fired because he reported to senior corporate officers that the company had engaged in corruption to curry favor with a government official in an effort to negotiate a lucrative business deal. When he was fired he had not (yet) reported the violations to the SEC. The Fifth Circuit affirmed the dismissal of his complaint, holding that the plain and unambiguous meaning of the statutory term “whistleblower” did not include anyone who had not yet reported any corporate misconduct to the SEC. It rejected the argument that the anti-retaliation provision was broader than the statutory definition of a whistleblower because it was plausible that an employee could simultaneously report corporate misconduct to both the company and the SEC, thus qualifying for protection. Based on this far-fetched hypothetical scenario, the Fifth Circuit refused to defer to the SEC’s contrary interpretation, and held that the statute’s plain and unambiguous language precluded its application to those who had only reported corporate misconduct to management.
Most federal courts, including the Second and Ninth Circuits, have disagreed with the Fifth Circuit’s reasoning. These courts have concluded that the anti-retaliatory provisions of the statute protect people who are protected or required under SOX, even if they do not meet the statutory definition of a whistleblower. They have held that the anti-retaliation provisions are, at least, in tension with each other if not independently ambiguous, justifying deferring to the SEC’s judgment that internal whistleblowers are protected by Dodd-Frank.
The Fifth Circuit’s reasoning would have an especially dramatic effect on auditors and attorneys, who are prohibited by SOX and SEC rules from filing reports with the Commission unless they first report corporate misconduct to senior managers or to a committee of the board of directors of the company. If they can be picked off before they have a chance to report violations to the SEC, companies may be able to stifle them. Auditors and attorneys played a central role in the Enron and other scandals, and the purpose and intent of SOX is to also regulate the behavior of these professionals. The Fifth Circuit utterly failed to address the impact of its decision on the obligations imposed by SOX on auditors and attorneys.
In Kokesh v. Securities and Exchange Commission, the Supreme Court recently applied the five-year statute of limitations to claims by the SEC for disgorgement of ill-gotten profits from violations of the federal securities laws. Dealing a blow to the SEC’s enforcement powers, the Court held that the disgorgement remedy is not primarily remedial but more closely resembles a “punishment” subject to the five-year limitation period. By forcing the SEC to move more quickly in these cases, the Kokesh opinion has actually helped plaintiffs in class actions and individual lawsuits. It should motivate the SEC to file actions at an earlier date, and thereby expose securities law violations sooner, better enabling private plaintiffs to file their own actions within the five-year statute of limitations that private plaintiffs face in bringing class actions and individual lawsuits.
In 2009, the SEC commenced an enforcement action against Charles Kokesh, who owned two investment advisory firms, seeking civil monetary penalties, disgorgement, and an injunction. The SEC alleged that between 1995 and 2009, Kokesh misappropriated $34.9 million from four business development companies and concealed this through false and misleading SEC filings and proxy statements. After a five-day trial, the jury found that Kokesh violated securities laws. The district court decided that $29.9 million of the disgorgement request resulting from Kokesh’s violations outside the limitations period was proper because disgorgement was not a “penalty” under §2462. The Tenth Circuit affirmed this decision, agreeing that disgorgement is neither a penalty nor forfeiture, so §2462 did not apply. The Court granted certiorari to resolve a circuit split on this issue, and in a unanimous decision authored by Justice Sotomayor, the Court reversed the Tenth Circuit.
Beginning in the 1970s, courts ordered disgorgement in SEC enforcement actions to deprive “‘defendants of their profits in order to remove any monetary reward for violating securities laws and to ‘protect the investing public by providing an effective deterrent to future violations.’” The Court had already applied the five-year statute of limitations for any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise,” when the SEC sought statutory monetary penalties. Disgorgement would also fall under this if deemed a “fine, penalty, or forfeiture.” A “penalty” is a “punishment, whether corporal or pecuniary, imposed and enforced by the State, for a crime or offen[s]e against its laws.” Whether disgorgement is a penalty hinged on two factors: first, whether the wrong to be redressed is one to the public or to an individual; and second, whether the sanction’s purpose is punishment and to deter others from offending in a like manner, as opposed to compensating a victim for her loss.
Second, the Court decided that disgorgement is a punishment. Disgorgement aims to protect the investing public by deterring future violations: “[C]ourts have consistently held that ‘[t]he primary purpose of disgorgement orders is to deter violations of the securities laws by depriving violators of their ill-gotten gains.’” Sanctions imposed to deter public law infractions are inherently punitive because deterrence is not a legitimate nonpunitive governmental objective. Moreover, disgorgement is not compensatory. Disgorged profits are paid to the district court, and it is within the court’s discretion how and to whom to distribute the money. District courts have required disgorgement regardless of whether the funds will be paid to investors as restitution: some disgorged funds are paid to victims; other funds are dispersed to the U.S. Treasury.
The Court found unpersuasive the SEC’s primary response that disgorgement is not punitive but instead remedial in lessening a violation’s effect by restoring the status quo. According to the Court, it is unclear whether disgorgement simply returns a defendant to the place occupied before having broken the law, as it sometimes exceeds profits gained from violations. For example, disgorgement is sometimes ordered without considering a defendant’s expenses that reduced the illegal profit. SEC disgorgement is then punitive, not simply restoring the status quo, but leaving the defendant worse off. Although disgorgement can serve compensatory goals, it can also serve retributive or deterrent purposes and be a punishment.
This decision puts limits on the SEC’s use of a favored tool—in recent years, the SEC secured nearly $3 billion in disgorgements, more than double what it received in penalties. But the decision should open doors for civil plaintiffs in class actions and individual lawsuits for violations of the federal securities laws. Within the five-year statute of limitations imposed on private civil plaintiffs, the SEC would now have to reveal to investors securities-law violations by companies and individuals who would be defendants in private lawsuits. This will better equip private civil plaintiffs to sue those defendants in a timely fashion. In any case, disgorgement is not a common remedy for private civil plaintiffs in securities lawsuits. Further, defendants who pay relatively less disgorgement in SEC enforcement actions may have more funds to satisfy parallel private civil lawsuits. Through closing the door on an element of the SEC’senforcement powers, the Court has opened several windows for private civil plaintiffs.
As the Monitor has reported, in the past year there have been numerous developments concerning the requirements for criminal liability for insider trading. Most recently, in U.S. v. Martoma, the Second Circuit revisited its 2014 decision in U.S. v. Newman and decided that there was no requirement, after all, that the recipient of the leaked information (the “tippee”) be a close relative or friend of the insider who leaked the information (the “tipper”).
The seminal case in this area is the 1983 Supreme Court decision in Dirks v. Securities and Exchange Commission.
When the Second Circuit decided Newman in 2014, it effectively put the brakes on much of the government’s expansive insider trader enforcement efforts. The Newman court overturned the convictions of two “remote” tippees, who had received the information indirectly from the original tippee. The Newman court held that the government must prove that the tipper had a “meaningfully close personal relationship” with the tippee, and that he expected “at least a potential gain of a pecuniary or similarly valuable nature” to support a finding of criminal liability for insider trading. This heightened standard required a showing that the tipper received some “tangible” benefit other than the satisfaction of rewarding the friend or relative – an interpretation rejected by other circuits. Further, the Second Circuit required that the government must also demonstrate the tippee knew that the tipper breached a fiduciary duty. This can present a major problem if the defendant is a remote tippee, such as colleagues of the original tippee at a brokerage firm, who may have little information of how the information was obtained and under what circumstances.
In Salman v. United States, the Supreme Court affirmed the defendant’s conviction for insider trading, unanimously holding that a jury may infer a personal benefit when a tipper provides inside information to a relative or friend, and that this is sufficient for a finding of criminal liability for insider trading. The Supreme Court went on to address the Second Circuit’s Newman decision, finding that any requirement “that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends” is inconsistent with Dirks.
On August 23, 2017, the Second Circuit affirmed the insider trading conviction of Mathew Martoma in a 2-1 opinion holding that the Supreme Court’s decision in Salman effectively overruled Newman’s requirement of a “meaningfully close personal relationship,” but did not disturb Newman’s other requirement that a tippee knew that the tipper breached a duty and received a benefit.
Martoma was a pharmaceutical and healthcare portfolio manager at S.A.C. Capital Advisors, LLC, (“S.A.C.”), a former group of hedge funds founded by Steven A. Cohen. During the course of his employment, he acquired shares of Elan and Wyeth, two companies that were developing an experimental Alzheimer’s drug. Martoma executed these trades based on information he obtained from the chair of the safety monitoring committee for the drug’s clinical trial, Dr. Sidney Gilman. The two of them met in approximately 43 consultations where, for some, Martoma paid Gilman $1,000 per hour. Dr. Gilman disclosed trial results and other confidential information to Martoma during these consultations.
Martoma and Gilman met twice, just before a conference at which Gilman was to present the clinical trial results of the new drug. After these two meetings but before the conference, S.A.C. began to reduce its positions in Elan and Wyeth. Following Gilman’s July 29 presentation disclosing that the drug failed to improve cognitive function in a test of 234 Alzheimer’s patients after 18 months of treatment, the share prices of Elan and Wyeth plummeted. The trades that Martoma’s hedge fund had made in advance of the presentation resulted in approximately $80 million in gains and $195 million in averted losses.
Martoma was convicted of insider trading and during his appeal, the Supreme Court decided Salman, doing away with the personal benefit requirement. Martoma argued that the jury instructions improperly ignored that he did not have a close personal or family relationship with the tipper.
The Second Circuit held that the logic of Salman meant that “Newman’s meaningfully close personal relation- ship requirement can no longer be sustained.” The Court held that “the straightforward logic of the giftgiving analysis in Dirks, strongly reaffirmed in Salman, is that a corporate insider personally benefits whenever he discloses inside information as a gift with the expectation that the recipient would trade on the basis of such information or otherwise exploit it for his pecuniary gain” – whether the recipient has a close personal relationship with the tipper or not.
Acknowledging a vigorous dissent that argued that Salman did not overrule Newman’s “meaningfully close personal relationship” requirement where inferring a personal benefit from a gift, the majority concluded that though the government must still prove that the tipper received a personal benefit, a “meaningfully close personal relationship” need not exist between tipper and tippee.
Though the Second Circuit dispensed with Newman’s “meaningfully close personal relationship” requirement, the other controversial Newman requirement, that the tippee knew the tipper provided inside information in exchange for some benefit, apparently remains intact. Additionally, it appears that one fact-sensitive evidentiary foray was replaced with another, with the government now having to prove “the expectation that the recipient would trade” based on inside information. En banc review of Martoma may also be on the horizon, as the dissent contended the Martoma court could not overrule Newman without convening en banc.

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