On Friday, June 20, 2014, the Securities and Exchange Commission filed an action against the Committee on Ways and Means of the U.S. House of Representatives and congressional staffer Brian Sutter seeking enforcement of subpoenas the SEC issued. The SEC is investigating whether laws against insider trading, specifically applicable to members and employees of Congress via the Stop Trading on Congressional Knowledge Act of 2012 (the “STOCK Act”), were violated by the disclosure of non-public information about Medicare reimbursement rates. This is pretty exciting stuff for securities lawyers. It isn’t everyday that one branch of the federal government sues another. (Generally, the facts set forth below are derived from the SEC’s court filing and have not yet been established as true in court.)

About a year after the STOCK Act became law, the SEC launched an investigation into whether information regarding the April 1, 2013 announcement by the U.S. Centers for Medicare and Medicaid Services (“CMS”) on the 2014 reimbursement rates for the Medicare Advantage program was leaked improperly prior to the official public announcement. In its brief filed with the United States District Court for the Southern District of New York, the SEC details the opening of a formal investigation to determine, among other things, the source(s) of information in an email sent from a lobbyist to a broker-dealer that issued a “flash report” indicating that certain Medicare reimbursement rates would actually increase, rather than decrease as had been expected. The flash report was issued approximately 40 minutes before the official CMS announcement regarding the reimbursement rates and was followed promptly by a dramatic increase in the price and trading volume of certain health care stocks.

On May 6, 2014 the SEC staff issued subpoenas to the House Committee on Ways and Means and Brian Sutter. Mr. Sutter is the Staff Director of the House Ways and Means Committee’s Healthcare Committee. Before becoming Staff Director, Mr. Sutter was a staff member to the Subcommittee. Both the Committee and Mr. Sutter have refused to comply with the subpoenas, citing a number of legal objections, including that the documents demanded are protected by the Constitution’s Speech or Debate Clause. The SEC is having none of that and, on June 20, 2014, the SEC filed an action to enforce subpoenas it issued in connection with its investigation, potentially setting up a Constitutional showdown.    

From my perspective, there are at least two interesting points here. First, the SEC appears to be aggressively enforcing the STOCK Act. Hopefully, the courts will find a way to support the SEC in its efforts to conduct the investigation. If the SEC cannot investigate, the STOCK Act may have little, if any, bite. (If you would like to read more about the STOCK Act, please see our summary in the April 2012 issue of Up to Date.) Second, it will be very interesting to watch the matter unfold from a Constitutional perspective.

Take Care When Using Finders

With good reason, many securities lawyers, myself included, cringe when they hear that a business client has engaged a “consultant” or “finder” to help raise capital rather than a registered broker.  Under Section 15(a) of the Securities Exchange Act of 1934, as amended, with some limited exceptions, it is unlawful for any person to effect any transactions in, or induce or attempt to induce the purchase or sale of, any securities unless the person is registered as a broker or dealer under the Exchange Act or associated with a registered broker or dealer.  What activities will require a person to register?  Even the SEC admits in its guidance on registering as a broker or dealer that it is not always easy tell.  However, one clear indicator that a person is probably acting as a broker or dealer is the person’s receipt of transaction-based compensation, such as a percentage of invested capital.    

The SEC recently announced that it had charged William M. Stephens with soliciting investments for two related investment funds while not registered as a broker under the Exchange Act.  As described in the Cease-and-Desist Order, with respect to investors introduced by Mr. Stephens, Mr. Stephens was to be paid one percent of amounts investors committed to invest.  In addition, Mr. Stephens provided various investment materials to prospective investors, such as private placement memoranda and subscription documents.   

Why should a company raising capital care if a consultant or finder is acting as an unregistered broker?  The involvement of an unregistered broker could give investors a right of rescission, that is, the right to require the company to buy back the securities the investor purchased at the original purchase price.  Obviously, the consequences of having to repurchase a large number of securities could be catastrophic as they were for Neogenix Oncology, Inc.  As detailed in a surprisingly frank series of letters  from Neogenix’s management to shareholders and Neogenix’s SEC filings, Neogenix’s use of unregistered finders to secure investments gave rise to up to $31 million of potential rescission liabilities.  These potential liabilities, and their impact on Neogenix’s ability to raise additional capital, ultimately contributed to  Neogenix’s decision to file for bankruptcy.

SEC Intensifies Scrutiny on Stock Sales by Insiders and 10b5-1 Plans

On February 5, 2013, the Wall Street Journal published the third in a series of articles discussing trading by public company executives in their companies’ securities, including trading pursuant to Rule 10b5-1 trading plans.  A 10b5-1 trading plan is a plan for buying or selling securities meeting the requirements of Securities Exchange Act Rule 10b5-1(c).  A properly adopted and implemented Rule 10b5-1 trading plan provides an affirmative defense against accusations of insider trading and allows the purchases and sales of securities even when the person who adopted the plan is aware of material nonpublic information. 

This latest Wall Street Journal article, “SEC Expands Probe on Executive Trades,” reports that the Securities and Exchange Commission has expanded its investigation into trading by corporate executives beyond the seven companies named in the first article in the series.  This latest article also refers to “shortcomings of the regulations” and “loopholes in the rules . . . known as a 10b5-1 plans.”  Whether or not you agree with the characterization of 10b5-1 plans as “loopholes” (I don’t), the Wall Street Journal’s recent reporting makes clear that trading by executives pursuant to 10b5-1 trading plans is likely to be subject to intense scrutiny in the coming months.  If you have not done so recently, now may be a very good time to review your company’s policies with respect to 10b5-1 trading plans and other insider trading policies to be sure they are adequate for today’s environment.  For some tips on what you may wish to consider in such a review, please see our December 2012/January 2013 Up to Date newsletter.

Chief of SEC’s Asset Management Unit Provides Compliance Tips for Private Equity Funds

On January 23, 2013, Bruce Karpati, Chief of the Asset Management Unit (“AMU”) of the Enforcement Division of the Securities and Exchange Commission, addressed the Private Equity International Conference held in New York.  The transcript of his presentation discusses potential compliance issues in the private equity industry on which the AMU may focus.  This presentation also serves as a useful guide for legal compliance professionals and executives serving the private equity industry highlighting certain areas on which they should focus.

In his comments, Mr. Karpati discussed the organization of the AMU and how the AMU has gained an expertise in the private equity industry.  Mr. Karpati explained that it is “not unreasonable to think that the number of cases involving private equity will increase” and he described a number of recent enforcement actions which highlight certain issues that may arise  at private equity firms.  Mr. Karpati stated that the AMU has found that some of the main industry stressors are fundraising and capital overhang.  In addition, Mr. Karpati indicated that many of the potential compliance issues in the private equity industry arise from conflicts of interest, such as the conflict between the profitability of the management company and the interests of investors, the shifting of expenses from one fund to another fund, and charging of additional fees to portfolio companies, especially where the permitted fees may be poorly defined by the fund’s limited partnership agreement.  In discussing conflicts of interests, Mr. Karpati stated that “Although conflicts of interest are a natural part of the private equity business, it is up to each manager to identify, control, and appropriately disclose material conflicts so that investors are informed and not harmed or disadvantaged.”     Finally, Mr. Karpati explained that private equity COOs and CFOs are critical in making sure that investors’ interests are paramount to the interests of the management company and its principals and discussed various ways that COOs and CFOs could reduce the risk of inquiry by the Division of Enforcement and ensure that their private equity firm and its principals are meeting their fiduciary responsibilities.

Lessons From a Recent SEC Enforcement Matter

On July 18, 2012, the SEC announced that it entered into a deferred prosecution agreement with the Amish Helping Fund (AHF).  AHF was formed in 1995 by a group of Amish elders interested in furthering the Amish way of life.  AHF offered and sold securities, the proceeds of which were used to fund mortgage and construction loans to young Amish families in Ohio.  The SEC asserted that AHF’s offering memorandum, drafted in 1995, was not updated for 15 years and contained material misrepresentations about the fund and the securities being offered.  When the SEC informed AHF of the alleged violations, AHF immediately cooperated, updated its offering memorandum and provided existing investors with a corrected copy of the updated  memorandum, offered all existing investors the right of rescission, and retained a certified public accountant to perform ongoing audits, among other things.  In its press release, the SEC emphasized that the SEC acknowledged and rewarded AHF’s cooperation.

What lessons can we learn from this enforcement matter?  First, that the securities laws apply without regard to the underlying reasons you are seeking to raise money.  Even when raising money for a “good cause”, such as helping young Amish families, when selling securities, compliance with applicable securities laws is still critical.  Second, offering materials must be reviewed and updated on a regular basis to reflect changes.  A company may not simply prepare a disclosure document, and then keep reusing the disclosure document from year to year without reviewing and updating it.  Updating is critical to providing accurate and complete information to investors.