Enforcement Watch

This edition of Enforcement Watch looks both at the messages of the enforcement cases in the last few months and at what changes on the horizon are likely to mean for firms and individuals in the shape of future enforcement.

Editor's Note

Whilst some of the old themes continue to be seen in enforcement cases, readers will see from our commentaries some new themes emerging and some novel issues coming up. Beyond that, in "On the Horizon", we see how the post Lehmans climate continues to be felt in the changes being introduced by the regulators. This is both in changes to the regulatory rules and to the practices being adopted by the regulators. We foresee these playing out in the enforcement field in future.

Vincent Filardo


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In the News

Two more SEC whistleblower awards and the first SEC action for retaliation against a whistleblower

The Securities and Exchange Commission continued to make use of its authority to reward whistleblowers, making two new awards to whistleblowers who provided information after their companies failed to internally address the improper activities. Additionally, for the first time, the SEC used its authority to take action against a firm that illegally retaliated against an individual who had provided information to the Commission.

On July 31 the SEC announced a $400,000 award to a whistleblower who provided information concerning a fraud that enabled the SEC to perform a more rapid investigation than would otherwise have been possible. The SEC notably highlighted the fact that the whistleblower had first tried to use internal company procedures to address the improper activity, but that the company refused to correct the problems.

Similarly, on August 29, the SEC announced a $300,000 award to a whistleblower who had audit and compliance functions at a company. According to the SEC, despite the employee’s reporting of potential wrongdoing to appropriate personnel within the company, the company took no action. The employee thereafter reported the same information to the SEC, which led directly to an SEC enforcement action.

Finally, on June 16 the SEC announced that it had, for the first time, used its authority under a rule adopted in 2011 to bring an anti-retaliation enforcement action. According to the SEC, Albany, N.Y.-based hedge fund advisory firm Paradigm Capital Management and its owner, Candace King Weir, improperly engaged in a prohibited principal transaction by conducting transactions with C.L. King & Associates, a broker-dealer that Weir owned. Neither Paradigm nor Weir disclosed the common ownership on both sides of the transaction to the client, in violation of securities laws. This misconduct was reported to the SEC by Paradigm’s head trader. Once Paradigm and Weir learned of the report, they purportedly took retaliatory measures against the trader which ultimately led to the trader’s resignation. Paradigm and Weir agreed to settle the SEC’s charges and pay disgorgement of $1.7 million, prejudgment interest of $181,771, and a $300,000 penalty for their alleged violations of the anti-retaliation rules and improper principal transactions.

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These new awards demonstrate the SEC’s willingness to take swift action where a company ignores internal reports of wrongdoing and then retaliates against the employee who made the report. These actions are further examples of the SEC’s demonstrated policy of providing cash rewards to those who come forward with information concerning fraudulent behavior, which is intended to encourage self-reporting and cooperation with governmental authorities.

Government agencies continue to obtain significant settlements from financial institutions

Government agencies have continued to aggressively pursue wrongdoing against large financial institutions, concluding four more settlements with U.S. banks.

On July 3, the Department of Justice announced a settlement with SunTrust Mortgage Inc. relating to the Department’s criminal investigation of SunTrust’s administration of the Home Affordable Modification Program. According to the Department of Justice, SunTrust misled mortgage servicing customers, making misrepresentations to borrowers and failing to process applications in a timely manner. SunTrust agreed to pay $320 million and implement remedial measures to resolve the investigation.

On July 24, the SEC charged Morgan Stanley & Co. LLC, Morgan Stanley ABS Capital I Inc., and Morgan Stanley Mortgage Capital Holdings LLC with misleading investors in a pair of residential mortgage-backed securitizations known as Morgan Stanley ABS Capital I Inc. Trust 2007-NC4 and Morgan Capital I Inc. Trust 2007-HE7. According to the SEC, the three Morgan Stanley entities misrepresented the current or historical delinquency status of mortgage loans underlying the securitizations. Morgan Stanley agreed to settle the charges by paying $275 million in disgorgement, prejudgment interest, and a penalty. This money will be placed into a fund designed to return money to injured investors.

On August 21 the U.S. Department of Justice and SEC announced a $16.65 billion settlement with Bank of America Corporation (BoA) -- the largest civil settlement with a single entity in American history -- to resolve a host of charges from a variety of federal and state agencies against BoA and current and former subsidiaries. The settlement includes a $5 billion penalty under the Financial Institutions Reform, Recovery and Enforcement Act, $7 billion of relief to affected individuals, and $1 billion to resolve claims by the Federal Deposit Insurance Corporation. BoA will also pay $943 million to settle the claims of California, Delaware, Illinois, Kentucky, Maryland, and New York. For the SEC’s part, BoA agreed to pay $245 million to resolve charges that it failed to provide important information to investors concerning known uncertainties regarding potential increased costs related to mortgage sales between 2004 and 2008. The settlement also resolves fraud charges brought by the SEC related to a residential mortgage-backed securities offering. The settlement requires BoA to admit wrongdoing and be monitored for compliance with the settlement obligations. It also does not absolve individuals from civil or criminal liability, nor BoA from potential criminal prosecution.

Finally, on September 12, the U.S. Federal Housing Finance Agency (FHFA) announced a settlement with HSBC to resolve alleged violations of federal and state securities laws by HSBC North America Holdings Inc. The claims relate to private-label mortgage-backed securities purchased by Fannie Mae and Freddie Mac between 2005 and 2007. The settlement calls for a payment of $550 million to Fannie and Freddie Mac.

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These settlements indicate that the U.S. government has not waivered on its policy of holding banks accountable for their unlawful mortgage lending related activities. The record settlement with Bank of America is noteworthy not only for its size, but also because it required the bank to admit a statement of facts and does not absolve it or its employees of liability. It is possible that such a significant settlement is, at least in part, a response to public concern in the United States that regulators believed some large financial institutions are "too big to fail", and thus could not be subject to significant civil and criminal penalties. Given the continued and significant prosecutions and settlements, there is no reason to believe that the U.S. government will cease its investigations and prosecutions of financial institutions believed to have engaged in fraudulent mortgage related activities. We expect to see further significant settlements with those financial institutions currently under investigation.

Settlements and prosecutions for LIBOR manipulation continue

U.S. government authorities have continued to pursue the entities and individuals responsible for manipulating the London Inter-Bank Offered Rate (LIBOR), recently resolving two more investigations.

On July 28 the Department of Justice announced that Lloyds Banking Group plc agreed to settle charges relating to its role in a scheme to manipulate LIBOR. As part of the settlement, Lloyds will enter a deferred prosecution agreement requiring an $86 million penalty and to admit and accept responsibility for misconduct set forth in an extensive statement of facts. Lloyds will also need to continue cooperating with the Justice Department’s ongoing investigation into LIBOR manipulation by other financial institutions. This latest settlement brings the total amount Lloyds has paid to financial regulators to almost $370 million. (See elsewhere in this edition "28 July 2014: Lloyds and BoS fined for LIBOR and other benchmark failings").

On August 18, British citizen Paul Robson, a former Yen trader for Dutch bank Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A. (Rabobank), pled guilty in a New York federal court to participation in a conspiracy to manipulate the Yen LIBOR. The prior month another former Rabobank trader, Japanese-national Takayuki Yagami, pled guilty to similar charges in New York federal court. Rabobank itself previously had agreed to settle the Department of Justice’s investigation by entering into a deferred prosecution agreement requiring a $325 million penalty. Notably, the Department of Justice highlighted the role of British and Dutch financial regulators in referring the case and assisting with the investigation of these former traders and Rabobank.

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Given its now longstanding efforts to combat LIBOR manipulation, and as discussed in Enforcement Watch 9 ("Banks continue to face legal and financial repercussions from the LIBOR scandal"), the U.S. government’s continued action against suspected LIBOR manipulators comes as no surprise. Still, these recent criminal dispositions are notable. First, unlike the mortgage backed securities investigations, the U.S. government is still targeting individuals involved in LIBOR manipulation, not just financial institutions. Second, the U.S. government is successfully working with its foreign counterpart governments on cross-border LIBOR investigations. The combination of active enforcement and international cooperation is likely to yield further prosecutions and settlements in the coming months.

Average prison terms for insider trading increase

According to a recent study published by Reuters, the length of U.S. federal prison sentences for individuals convicted of insider trading have been increasing in recent years, and have reached an average sentencing level that would have been unthinkable just a few decades ago.

Between 2008 and 2013, prison sentences for insider trading convictions increased by 31.8% to an average of 17.3 months. Indeed, in the past few years there have been several notable sentences: in 2011 Raj Rajaratnam was sentenced to eleven years, in 2012 Matthew Kluger was sentenced to twelve years, and just recently Mathew Martoma received a nine-year sentence.

These longer sentences are at least due in-part to what appears to be a reliance on the federal sentencing guidelines. The guidelines are no longer mandatory, but their usage remains a prevalent and persuasive tool of federal prosecutors, and judicial guidepost for federal criminal sentencing. Notably, the guidelines take into account the amount of loss involved in insider trading which provides an upward departure from the base guideline sentencing level for such crimes. Moreover, the guidelines (as amended in 2012), provide a minimum sentence of 15-21 months for those involved in an “organized scheme” to trade on confidential information, as is typically the case in most insider trading actions. Since the financial crisis of 2008, the U.S. Department of Justice has aggressively prosecuted suspected insider trading and similar criminal offenses. The New York Times has commented that the judiciary in the United States District Court for the Southern District of New York – where a large percentage of the insider trading cases are prosecuted – endeavor to match each other’s sentences so that sentencing terms will be consistent for similar crimes, and not otherwise affected by random events, such as the court’s independent judicial assignment system for all new cases. The result has been the imposition of increasingly longer sentences after conviction or guilty plea. It is also notable that U.S. courts have been imposing more prison sentences (rather than monetary punishment) for insider trading than ever before.

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The Reuters' report demonstrates that, since the financial crisis of 2008, the U.S. government and judiciary are aggressively prosecuting and severely punishing financial related crimes. Given the request for and imposition of increasingly extreme sentences by the U.S. government and judiciary, it is more important than ever for defense strategies to include an analysis of prison exposure and how it may be limited through and by cooperation with the government.

 To read more about enforcement action in the UK, please click here.