The United States Sentencing Commission recently unveiled a number of key amendments to the Federal Sentencing Guidelines regarding securities fraud, insider trading, and financial institution fraud.  According to a Commission news release, the amendments respond to Dodd-Frank Act directives instructing it to review and amend the guidelines’ application in fraud cases.  Judge Patti B. Saris, chair of the Commission, summed up the amendments:  “The Commission’s action . . . increases penalties for insider trading cases and ensures that no defendant will receive a reduced penalty because of a federal intervention, such as a bailout.”

As the Wall Street Journal reported, “recent insider-trading defendants have received considerably harsher sentences than similar offenders in the past.”  Yet the proposed sentencing guidelines amendments will empower prosecutors to recommend sentences that are harsher still.  For its part, the defense bar believes the penalties are already sufficiently severe, though the Justice Department insists tougher sentences are required to ensure that insiders will not act on temptations to trade. 

Securities Fraud & Insider Trading

The amendments make two significant changes in securities fraud and insider trading cases.  First, they amend the securities fraud guideline “to provide a special rule for determining loss in cases involving the fraudulent inflation or deflation in the value of a publicly traded security or commodity.”  The courts are instructed to employ the “modified rescissory method” in calculating the loss attributable to the change in value, which requires calculating the difference between the price of the security when the fraud occurred and the price of the security after the fraud was disclosed, and multiplying that figure by the total shares outstanding.  The amendment creates a “rebuttable presumption” that the figure arrived at through this calculation amounts to the “actual loss” for sentencing purposes, though defendants may challenge the number with proof that “other factors” resulted in the change in value.  “Other factors” might include overall market fluctuations or indicia of economic or industry instability.

Second, the amendments create a new minimum offense level for insider trading involving “an organized scheme” and allow for a sentence enhancement in cases where the offender used “a position of trust” (such as one “that involved regular participation or professional assistance in creating, issuing, buying, selling, or trading securities or commodities”) to “facilitate significantly the commission or concealment of the offense.” 

Mortgage & Financial Institution Fraud

The amendments alter the guidelines regarding mortgage fraud and financial institution fraud in two important ways.  First, the amendments “change how the fair market value of the collateral is determined in the case of a fraud involving a mortgage loan.”  Essentially, the value of the collateral is the market value as of the date the defendant pleaded or was found guilty.  The amendments create a “rebuttable presumption” that the fair market value is the “tax assessment value,” though the defendant may present evidence that the tax assessment value is an unreasonable measure. 

Second, the amendments provide sentence enhancements for crimes resulting in financial harms that “jeopardize[e] a financial institution or organization.”  The amended guideline lists a number of “harms” the court should consider, such as the risk of insolvency.  The courts are instructed to devise a sentence based on the likelihood that the threat would have caused harm, irrespective of whether the financial institution was spared injury by government intervention, such as a “bailout.”

Departures from the Guidelines

Importantly, the amendments provide guidance for the courts in departing from the sentence range calculated under the guidelines.  An upward departure is warranted where “the offense created a risk of substantial loss” beyond the calculated “actual loss.”  This might be appropriate in cases where the wrongdoing posed “a risk of significant disruption of a national financial market.” 

The amendments allow for a downward departure in cases where the recommended sentence range “substantially overstates the seriousness of the offense.”  This may be proper where the aggregate loss flowing from the misconduct is large, but the result is “small loss amount suffered by a relatively large number of victims.”  

Impact

The Commission must submit its amendments to Congress by May 1^st.  Absent Congress’ modification or disapproval, the amendments will be effective as of November 1, 2012. 

It will be months before the impact on these amendments is apparent.  And road ahead appears to have more twists and turns.  The Commission has made clear that the amended guidelines are unlikely to be the last iteration of the rules as they relate to fraud cases.  Judge Saris regards the amendments as only “the first step in a multi-year review of the fraud guideline.”  “This is an area of the guidelines,” she says, “that the Commission must continue to review in a comprehensive manner.” 

In advance of the run up to an historic hearing held by the House Administration Committee , the Political Law Group at McGuireWoods recently sent this letter  (click on Berke letter) to the Committee on House Administration.  As we stated in our letter,   we believe that more guidance is needed by the FEC to assist campaigns in complying with federal election laws.  We also stated:               

During a hearing held by the FEC in 2009, a discussion occurred regarding the need for the Commission to make public its internal enforcement manual and guidelines.  The lack of transparency that binds FEC Office of General Counsel attorneys in their negotiations and dealings does a disservice to both the FEC and respondents to enforcement proceedings.  If the Department of Justice can recognize the public interest in making available its U.S. Attorneys’ Manual, the FEC can most certainly do the same with respect to its enforcement guidelines.  We encourage you to make this request to the Commissioners appearing before your Committee on November 3.    

We're happy that all of the FEC Commissioners appearing at the hearing appeared to agree with our position.  We thank the House Administration Committee for holding this important hearing, and the FEC Commissioners for appearing as witnesses.  

If the ABA has its way, Congress will significantly reform the thresholds for lobbyist registration.  The ABA House of Delegates, acting on the recommendation of a special task force on lobbying reform, voted this week to support significant reforms.   A recent article in Roll Call took a good look at the issue, reporting:

The ABA wants to narrow the threshold at which a lobbyist must register from 20 percent or more of the time spent on lobbying activities for clients to some “reasonable” but unspecified amount that would be “designed to avoid imposing undue financial burdens” on smaller or one-man shops. The association also proposed a two-year window during which lobbyists could not lobby Members for whom they have raised money or raise money for Members they have lobbied in the past.

Don't expect congressional action any time soon, however.  Congress has been more inclined to react to scandal rather than calls for reform when looking to change lobbying law (such as the passage of HLOGA in 2007).

A letter sent by Republican Senators to the Commissioner of the IRS questions the retroactive enforcement of the gift tax in a highly politicized environment noting that President “Obama and the White House have made it clear they view section 501(c)(4)s with deep hostility and that the (White House) Staff fear their ability to influence an election.”  The last comment evidently was in reference to the 2008 election and the Supreme Court decision in the Citizen United v. FEC that ruled corporations may spend unlimited amounts of money supporting or opposing political candidates for office as long a they do so independently of candidate and political parties. This decision encouraged funding of a number of 501(c)(4) advocacy organizations that support specific candidates.  Under the IRS Code and Regulations, 501(c)(4) organizations can participate in electoral activity as long as the activity is not the “primary activity” of the organization.

What makes this matter very interesting is Commissioners Shulman’s defense of the IRS and the reason for the current examinations, i.e. “the agency is apolitical and non partisan,” no involvement by any political appointee inside or outside of the agency.  This was a direct response to the Congressional letter inquiring whether outside sources had influenced the initiation of the examinations.

The Congressional letter was a not so subtle reference to “President Nixon’s Enemy list” that identified specific individuals and organizations for IRS Audit in 1973, during that election period,  that were at odds with the administration’s policy on Vietnam, the cities, the environment and many other social welfare issues.  Fortunately, the IRS did not then succumb to those pressures and hopefully as indicated by Commissioner Shulman’s statement that the IRS would not be directed by outside forces to initiate partisan audits.

 Background to this Brouhaha

The IRS has attempted to apply the federal gift tax under IRC section 2501(a) to amounts contributed to campaign funds of candidates for certain political offices and to amounts expended directly on their behalf.  In only two reported cases decided over 30 years ago, the IRS attempted to assert the gift tax to these donations.  See Carson v. Commissioner 71 T.C. 352 (1978) and Stern v. United States, 436 F.2d. 1357 (5^thCir. 1971).  The Courts there held that the gift tax did not apply to amounts contributed directly on behalf of candidates.  In 1982, the IRS issued a public acquiescence to the result reached in these cases.  Rev. Rul. 82-216, 1982-2 C.B. 220, held that the IRS would no longer contend that the gift tax applies to contributions made to or on behalf of organizations described in section 527(e)(1).  However, the Service also indicated that it continues to maintain that gratuitous transfers to “persons other than organizations described in section 527(e) are subject to the gift tax absent any specific statute to the contrary.”

There are no published IRS positions that it has applied the rationale in this Rev. Rul.  82- 216 to 501(c)(4) organizations or other 501(c) organizations  for 29 years since the Rev. Rul. was issued.

After the Supreme Court's 2010 decision in Citizens United, much of the debate focused upon how the ruling would open the door for more corporate and union political activity.  While no significant for profit corporate activity arose during the 2010 election cycle, there was an increase in political activity by corporate non-profits (and of course unions).  However, as Politico recently reported, the broader impact of Citizens United may prove to be on the permanency of the campaign process, not just on heightened participation during election season.  The phrase "permanent campaign" has been in our political lexicon for some time, but the concept has unquestionably now taken root, with political activity seamlessly continuing from one election cycle to the next:

Just one month after the 2010 midterms, the conservative Crossroads GPS launched $400,000 in radio ads pushing Democrats to extend the Bush tax cuts. The group spent another $450,000 last month in key House districts, plus $750,000 more in recent ads about the Wisconsin labor fight.

The Susan B. Anthony List, American Future Fund and Americans for Prosperity also are putting up ads, sending mailers and financing election-style bus tours — all feeding into a non-stop, two-year campaign against the Democrats heading into 2012.

It is important to remember that Citizens United was a campaign finance decision – not a tax law decision.  As Politico went on to discuss, the aforementioned groups are “essentially charities’ requiring them “to prove to the IRS that they deserve that special, non-political status, and the perks that go along with it.”  Although the FEC is in the process of finalizing its post-Citizens United rule making, the IRS has been fairly circumspect. The landscape, therefore, remains ambiguous.  With this permanent campaign will come the need for permanent -- and more rigorous -- compliance.  Non-profit corporations engaging in political activity by in particular must therefore understand the legal and regulatory restrictions that continue to evolve in the post-Citizens United world. 

In May 2009, in the wake of the “Great Recession,” President Obama signed into law the Fraud Enforcement and Recovery Act, which established the Financial Crisis Inquiry Commission.  According to the FCIC’s website, the Commission was created to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.”  To that end, the FCIC was charged with examining fraud and abuse in the financial sector, the efficacy of federal and state financial regulators, and the structure of legal and regulatory schemes in the financial sector. 

In a Fact Sheet presented at the First Public Hearing of the FCIC on January 13-14, 2010, the Commission highlighted numerous financial fraud cases undertaken by the DOJ and SEC.  At the time, the DOJ was pursuing some 500 mortgage fraud related charges, with 2,700 additional investigations pending.  Meanwhile, the SEC was engaged in 664 enforcement actions. 

And it looks like the financial fraud business will continue to boom for the Feds. According to Sewell Chan of the NY Times, the FCIC recently made a number of referrals to the Justice Department “as a precaution to ensure that federal authorities were aware of potential misconduct the panel came across during its yearlong investigation.”  Most of the referrals involve possible violations of federal securities laws and, according to a source who spoke to the Huffington Post under condition of anonymity, civil investigation will be the most likely outcome of the referrals. 

The FCIC recently announced  that it will release its full report on the causes of the financial crisis on Thursday, January 27th, and Mr. Chan of the NY Times tells us it “will probably reignite debate over the outsize influence of Wall Street; it says that regulators ‘lacked the political will’ to scrutinize and hold accountable the institutions they were supposed to oversee.”

Like the 9/11 Report, the 567-page FCIC report, which includes “dissents” from Republican members of the Commission, will undoubtedly become a best seller.  And while it may not be as popular a read among the “alphabet soup of regulatory agencies” blamed for the 2008 financial crisis, it will be interesting to see the DOJ and SEC response. 

As any company who has gone through it will tell you, informal government investigations and internal investigations can be costly affairs.  Many companies hope to defray those costs with organization and executive liability insurance policies.  Does your liability insurance policy cover costs incurred in connection with a government or internal investigation?  According to a recent decision in the Southern District of Florida, it may not. 

On October 15, 2010 in Office Depot v. National Union Fire Insurance Company of Pittsburgh, PA and American Casualty Insurance Company of Reading, PA, the Southern District of Florida found that certain investigatory costs did not fall within “the policy’s definition of loss ‘arising from’ a covered ‘Securities Claim’ made against Office Depot, or a covered ‘Claim’ made against one of its officers, directors or employees….”  This was a significant result for Office Depot, who sought reimbursement of more than $23 million in costs and expenses. 

The Court’s decision in Office Depot is not always the outcome, however.  In December 2009, the Southern District of New York ruled in MBIA, Inc. v. Federal Insurance Co. and ACE American Insurance Co., that MBIA’s policy did cover the investigatory expenses at issue.  The outcome was surely well received by MBIA, who claimed to have spent $29.5 million “for the costs of defending and responding to the regulatory investigation[s] and follow-on litigation.” 

Why the different findings?  The answer lies in the Courts’ close analysis of the specific language in the companies’ insurance policies, as well as the facts surrounding the government and internal investigations.  While the Office Depot and MBIA rulings may not allow you to predict the result of an insurance coverage dispute, they do reveal an important principle: Your company needs to look closely at its organization and executive liability insurance policy.  How does the policy define “claim” (and/or “securities claim”)?  Does it cover administrative or regulatory investigations or proceedings?  Must a regulatory agency issue a formal order before your policy kicks in? 

Kevin M. LaCroix of The D&O Diary has written very helpful reviews of both cases.  For his take on the Office Depot matter, click here.  For his breakdown of the MBIA case, click here. 

The bottom line: Businesses that may be subject to government inquiry or caused to undergo internal investigations would be well advised to spend some time wading through your insurance policy now, and avoid spending for investigatory costs later. 

With three lawsuits now pending in federal court to exempt certain professions from the reach of the Red Flags Rule and two bills pending in the Congress to do the same, the FTC determined that it was best to once again further delay enforcement of the identity theft prevention regulation past the current enforcement deadline of June 1.

In a press release and enforcement policy statement, the FTC announced today that it is delaying its enforcement of the Red Flags Rule through December 31, 2010. The Red Flags Rule requires covered businesses to establish and implement Identity Theft Prevention Programs in order to detect, prevent, and mitigate identity theft.

The FTC asserts that several members of Congress have again asked the Commission to delay enforcement in order to give Congress time to work through its pending legislation regarding the scope of businesses that should be covered by the Rule. H.R. 3763 (pdf) passed 400-0 last year and has received no Senate action. Meanwhile, a companion S. 3416 (pdf) was introduced in the Senate just before the Memorial Day holiday.

Notably, the FTC made no mention of the three federal cases now pending against it. As reported earlier on this blog, on May 21, the American Medical Association joined the American Bar Association and the American Institute of Certified Public Accountants in filing suit against the FTC to exempt its members from the reach of the Red Flags Rule.

The FTC urged Congress to act quickly on its pending legislation. The Commission stated that, if Congress passes legislation limiting the scope of the Red Flags Rule with an effective date earlier than December 31, 2010, then the Commission will begin enforcement as of that effective date.

This further delay of the enforcement deadline gives non-bank businesses the extra time they need to determine whether they are subject to the Red Flags Rule and, if so, to perform a suitable risk assessment that will assist in the establishment of an appropriate Identity Theft Prevention Program. Banks and other financial institutions that are subject to supervision by a federal bank regulatory agency should already have such a program in place.