Enforcement and Prosecution Policy and Trends September 18, 2018

Mulvaney’s First New Enforcement Action Continues Focus on Asset-Advance Firms

In the latest sign of regulatory scrutiny of asset-advance companies offering consumers what regulators believe are in fact regulated “credit” under federal law and “loans” under state law, the Bureau of Consumer Financial Protection (BCFP) filed its first new lawsuit under Acting Director Mulvaney last Thursday. The complaint, filed in the Central District of California, alleges that a so-called pension-advance company, Future Income Payments, LLC, its President and affiliates falsely marketed high-interest loans as mere purchases of consumers’ rights to future cash income streams on pensions and other assets.

This action continues the Bureau’s and state regulators’ focus on such asset-advance enterprises: see action against Pension Funding, LLC and others here; action against RD Legal Funding, a litigation settlement advance company, here; and the Bureau’s 2015 “Consumer advisory: 3 pension advance traps to avoid.” In its new complaint, the BCFP complaint alleges that the defendants failed to treat their products as “credit” and “loans,” and alleges violations of the Truth-in-Lending Act and the Consumer Financial Protection Act for (i) failure to follow federal credit disclosure requirements, (ii) engaging in deceptive marketing practices, and (iii) failure to follow various state laws governing “loans.”

In this case, the BCFP specifically alleged that Defendants, based in Irvine, CA, lured senior citizens, disabled veterans, and other vulnerable consumers into borrowing money at deceptively high interest rates. The company allegedly offered consumers lump-sum payments of up to $60,000 in exchange for their assigning to the company a larger amount of their future pension and other income streams. Marketing the product as a “purchase” and not a loan, the company allegedly claimed that the advance was interest-free and a useful way to pay off credit card debt. In fact, the Bureau alleges, the discount applied to consumers’ future income streams was a disguised form of interest, equivalent to rates of up to 183%.

Interestingly, though, the Complaint does not address exactly why the challenged transactions are, in fact, extensions of “credit” under the federal Truth-in-Lending Act’s definition of that term and “loans” under state law. We will continue to track the Bureau’s analysis of those issues, because they are arising repeatedly as Fintech and other new companies develop products that seek, in a wide variety of forms, to offer consumers advances in exchange for future cash streams.

Enforcement and Prosecution Policy and Trends September 7, 2018

Second Circuit Clarifies Limits of FCPA’s Extraterritorial Reach

By Patrick Rowan, Alex J. Brackett and Lauren Cafferty Mahaffey

The U.S. Court of Appeals for the Second Circuit narrowed the reach of the Foreign Corrupt Practices Act (“FCPA” or “the Act”) in ruling that the government cannot use aiding and abetting or conspiracy statutes to charge a defendant with violating the FCPA if the defendant is not in the category of persons directly covered by the Act.

Defendant Lawrence Hoskins, a UK citizen, worked for a UK subsidiary of Alstom S.A. The government alleged that Hoskins was involved in authorizing payments by a U.S. subsidiary of Alstom to consultants who bribed Indonesian officials. The Court rejected the government’s theory that Hoskins could aid and abet or conspire to commit a violation of the FCPA, but left open the theory that he may fall into one of the categories covered by the Act as an agent of a “domestic concern” (Alstom’s U.S. subsidiary). Three categories of persons are subject to the Act: 1) issuers of securities and their officers, directors, employees, shareholders and agents; 2) U.S. persons and companies and their agents; and 3) foreign persons or businesses taking actions while present in the U.S. For purposes of the ruling, the Court assumed Hoskins was not an agent of Alstom’s U.S. subsidiary.

Hoskins was a non-resident foreign national, acting outside the U.S., who did not work for a U.S. company during the alleged scheme, and never visited the U.S. Rejecting the DOJ’s long held theory of the FCPA’s expansive reach, the Court held that the omission of this category of persons from the Act by Congress “was a limitation created with surgical precision to limit [the FCPA’s] jurisdictional reach.” Thus the government could not use conspiracy and aiding and abetting statutes to reach Hoskins.

According to the Second Circuit, foreign nationals can only be liable under the FCPA if they: 1) acted in the U.S.; 2) were officers, directors, employees or shareholders of a U.S. company; or 3) were agents of a U.S. company. To hold Hoskins liable, the government will have to demonstrate that he was an agent of the U.S. subsidiary of Alstom.

The Second Circuit’s decision is illuminating on the reach of the FCPA, but the impact on future enforcement actions may be limited given the range of other theories available to the government, including the agency liability theory that remains alive in Hoskins.

Enforcement and Prosecution Policy and Trends July 16, 2018

Implications of Judge Kavanaugh’s Nomination for Criminal Sentencing

By Benjamin Christenson

Imagine an individual who is convicted of fraudulently obtaining $5,000 but simultaneously acquitted by a jury of conspiring to fraudulently obtain $1 million. Yet at sentencing, the court bases its sentence of the defendant not on the $5,000 fraud of which he was convicted but on the $1 million conspiracy for which the judge finds him culpable. Under the federal sentencing guidelines, the dollar amount of a fraud or theft is a primary determinant of the recommended sentence. Although the guidelines sentence is only advisory, the judge is required to calculate and consider it; in this circumstance, a defendant’s sentence could potentially increase from probation to three years. Yet even though the court has in some way contradicted the jury’s verdict, such a result is in many cases allowed under current law. Besides seeming unfair, the ability of prosecutors to use acquitted conduct at sentence may allow them to bring more numerous charges against defendants under the assumption that even if the jury acquits the defendant on the majority of charges that same conduct will still be available at sentencing.

The justification for a court’s use of acquitted conduct at sentencing is that under current law a judge may find facts by a preponderance of evidence at sentencing, a lower standard than the beyond a reasonable doubt standard the jury uses. Yet a number of judges have expressed concern about the potential violation of the Sixth Amendment Right to Jury Trial implicated by these facts. Justices Scalia, Thomas, and Ginsburg raised concerns regarding similar issues in a dissent from a denial of a cert petition. Donald Trump’s recent Supreme Court nominee, Judge Brett Kavanaugh, has also indicated his sympathy to the idea that a court sentencing a defendant on the basis of acquitted conduct seems unjust. In one case, he echoed and endorsed a defendant’s words that the defendant “just fe[lt] as though, you know, that that’s not right. That I should get punished for something that the jury and my peers, they found me not guilty.” Judge Kavanaugh has also written that even though judges may sentence on the basis of acquitted conduct, they have the discretion to effectively ignore that conduct and impose a lower sentence.

Judge Kavanaugh’s writing on this topic, however, has always noted that binding precedent from the Supreme Court and his own D.C. Circuit permits sentencing on the basis of acquitted conduct. Should Judge Kavanaugh be elevated to the Supreme Court, he would be in a position to do something about that in conjunction with other Justices who have expressed similar concerns.

Enforcement and Prosecution Policy and Trends July 16, 2018

Supreme Court Narrows Ability to Recover Internal Investigation Costs

By Michael Baudinet

In January, this blog previewed the Supreme Court’s grant of certiorari in Lagos v. United States to resolve a circuit split regarding whether companies could recover costs of internal investigations under the Mandatory Victims Restitution Act (MVRA). At the end of May, the Court issued a unanimous opinion sharply curtailing the ability to recover such costs.

The MVRA allows victims of financial fraud to recoup expenses caused by the criminal activity. Before Lagos, six circuits read the MVRA’s provision mandating reimbursement for “expenses incurred during the participation in the investigation or prosecution of the offense” to apply broadly to costs that were “foreseeable.” Only the DC Circuit disagreed with this interpretation, limiting reimbursement for internal investigations only to those that were directly requested or required by the government. In Lagos, the Fifth Circuit joined the other six circuits holding that the MVRA required a freight company’s CEO to repay a defrauded lender’s costs of conducting an internal investigation to uncover the scheme. The Fifth Circuit also found that the MVRA covered the lender’s attorney’s fees in the freight company’s bankruptcy proceedings.

In an opinion by Justice Breyer, the Supreme Court held that the MVRA “does not cover the costs of a private investigation that the victim chooses on its own to conduct.” In fact, the MVRA does not cover the costs of an investigation conducted before the government’s investigation even if the victim shares that information with the government. Nor does the MVRA cover costs associated with ancillary civil proceedings like a bankruptcy case, human resources review, or licensing proceeding. In fact, while the Court expressly declined to address the D.C. Circuit’s view about whether the MVRA covered the costs of investigation requested by the government, some of its reasoning hinted at an even more restrictive interpretation. In particular, the Court expressed concern about district courts reviewing the results of an internal investigation to determine which witness interviews or document reviews were “really ‘necessary’ to the investigation.”

In light of Lagos, corporate counsel should expect that most internal investigation costs – and certainly any costs for ancillary proceedings – will not be reimbursable under the MVRA. In situations where recovering investigative costs might be a priority, corporate counsel should consider partnering with law enforcement as early in the process as possible. Counsel should carefully document the specific request from law enforcement – and even consider requesting a subpoena – to ensure that each action would be considered a “necessary” component of the government’s investigation.

Enforcement and Prosecution Policy and Trends May 29, 2018

State Regulators Announce Cryptocurrency Crackdown

By Nicholas B. Lewis and Brian C. Wanglin

On May 21, the North American Securities Administrators Association (“NASAA”) announced a massive and coordinated series of enforcement actions by U.S. state and Canadian provincial regulators to combat fraudulent practices involving cryptocurrency-related investment products.

As cryptocurrencies have gained in popularity, companies have increasingly turned to a method known as an initial coin offering (“ICO”) to raise capital. ICOs, however, are ripe for potential fraud. As the Washington Post has explained, “consumers face higher risks of being misled at a time when the intense demand for bitcoin has prompted many retail investors to take extreme steps to gain exposure to the currency…”

Given ICOs’ high risk of fraud, state regulators are increasingly scrutinizing such offerings as well as other practices involving cryptocurrency-related investments. In fact, according to NASAA, state regulators have opened nearly 70 inquiries and investigations into cryptocurrency-related companies. Moreover, there are 35 pending or completed enforcement actions related to ICOs or cryptocurrencies since the beginning of May. In short, state agencies are using state securities laws to crack down on fraud and deception in the cryptocurrency market.

These coordinated state actions have caught the attention of federal regulators as well. U.S. Securities and Exchange Commission (“SEC”) Chairman Jay Clayton issued a statement praising the NASAA for taking action. Chairman Clayton warned “fraudsters in this space that many sets of eyes are watching, and that regulators are coordinating on an international level to take strong actions to deter and stop fraud.” Chairman Clayton further reminded investors that “regulators are committed to protecting investors in these markets.”

As the recent NASAA announcement and SEC Chairman Clayton’s comments demonstrate, regulators in the United States and abroad are increasingly turning their attention to the cryptocurrency market. The intensifying spotlight on ICO’s and cryptocurrency should encourage companies pursuing an ICO or other activities involving cryptocurrency-related investments to seek legal counsel and to comply with all state laws, federal laws, and SEC regulations.

Enforcement and Prosecution Policy and Trends, Fraud, Deception and False Claims May 25, 2018

Series of DOJ Enforcement Policy Announcements Provides Promising Guidance

By Alex J. Brackett and Mark L. Earley

In a series of key policy announcements between November 2017 and May 2018, the Department of Justice has demonstrated an increasingly coherent perspective on how it will handle key aspects of white collar criminal enforcement. The policies largely reiterate a message federal prosecutors have delivered for years regarding what they want to see from companies that discover misconduct in their ranks: prompt voluntary self-disclosure of violations; full cooperation with DOJ investigations; swift, meaningful remediation; and implementation and maintenance of effective compliance programs. What is different is the increasing certainty DOJ is willing to provide in return, including concrete benefits such as a presumption of declination or significant reduction of penalties. DOJ is also seeking to deliver more rational resolutions to complex cases to prevent “piling on” by multiple enforcement agencies in the U.S. or abroad — a policy that reflects the increasing reality and inequity many companies face when seeking to resolve large-scale white collar matters across an often balkanized and disjointed enforcement landscape.

We are early in the assessment of this still-developing evolution of DOJ policy, but on initial review these seem to be positive steps of which companies of all sizes should take heed.

DOJ Announcements

In November 2017, Deputy Attorney General Rod Rosenstein announced the implementation of a revised Foreign Corrupt Practices Act (FCPA) Corporate Enforcement Policy, which followed and supplanted a multi-year FCPA Pilot Program that had been initiated under the Obama Administration. Rosenstein noted in announcing the new policy that it “enables the Department to efficiently identify and punish criminal conduct, and it provides guidance and greater certainty for companies struggling with the question of whether to make voluntary disclosures of wrongdoing.” Justifying this new policy, he stated that “[t]he government should provide incentives for companies to engage in ethical corporate behavior. That means fully cooperating with government investigations, and doing what is necessary to remediate misconduct — including implementing a robust compliance program. Good corporate behavior also means notifying law enforcement about wrongdoing.”

The new policy’s primary thrust is that if a company “satisfies the standards of voluntary self-disclosure, full cooperation, and timely and appropriate remediation, there will be a presumption that the Department will resolve the company’s case through a declination.” That presumption can be overcome if there are aggravating circumstances, or if the offender is a recidivist. Importantly, this new policy has been incorporated into the U.S. Attorneys’ Manual, a step Rosenstein has made clear over the past few months should and will be DOJ practice going forward whenever new polices are put in place.

On March 1, 2018, John Cronan, acting assistant attorney general for the Criminal Division, took this new policy a significant step forward by publicly announcing that the principles of the FCPA Corporate Enforcement Policy would not stay confined to FCPA actions, but would also be applied to all of the Criminal Division’s corporate criminal investigations as non-binding guidance.

The next day, Rosenstein explained this shift during remarks at an event in San Diego, stating that corporate America “is often the first line of defense for detecting and deterring fraud” and that real compliance measures “help the department preserve its finite resources.” Further, he made clear that DOJ wants to “reward companies that invest in strong compliance measures.” Rosenstein assured the audience that DOJ will not “employ the hammer of criminal enforcement to extract unfair settlements” but is “committed to finding effective ways to ensure that individual wrongdoers are held accountable for corporate criminal behavior.” And while he reaffirmed that of course corporate misconduct can be “serious or pervasive enough” to warrant action against an entity, the DOJ will “think carefully about accountability and fairness.”

Two weeks ago, Rosenstein announced yet another policy shift to encourage “coordination” among law enforcement when “imposing multiple penalties for the same conduct” and to “enhance relationships with … law enforcement partners in the United States and abroad, while avoiding unfair duplicative penalties.” Through its third major policy announcement in six months, DOJ is seeking to “discourage disproportionate enforcement of laws by multiple authorities” – “piling on,” so to speak. Rosenstein made clear in his remarks that such piling on can deprive companies of certainty and finality, and harm “innocent employees, customers, and investors who seek to resolve problems and move on.”

This so-called “piling on” policy has four essential features. First, it affirms that “criminal enforcement authority” shouldn’t be used “for purposes unrelated to the investigation and prosecution of a possible crime” (i.e., DOJ shouldn’t threaten prosecution simply to induce a larger settlement). Second, it encourages coordination among law enforcers to achieve an “overall equitable result.” Third, DOJ attorneys are encouraged to “coordinate with other federal, state, local, and foreign enforcement authorities seeking to resolve a case with a company for the same misconduct.” Fourth, several factors are established to evaluate whether multiple penalties are justified in a particular case, such as egregiousness, statutory mandates, risk of delay in finalizing a resolution, and the quality of a company’s disclosures and cooperation.

Policy Evolution

The DOJ has historically moved at a very deliberate pace from an enforcement policy perspective, and has been loath to cede discretion or flexibility in how it resolves high-stakes investigations. That makes this relative flurry of policy announcements potentially significant. Although DOJ has certainly retained a significant amount of prosecutorial discretion, it has anchored these policies on far more concrete benefits to cooperating corporations. For many companies navigating the discovery of potentially significant corporate misconduct, these policies could make the decision whether to self-disclose easier. At least, that is the clear hope for DOJ.

These policies also appear calibrated to address a few other key DOJ principles:

Compliance Programs Are Critical: The importance for corporations to implement and operate robust and effective compliance programs is nothing new. This concept has for years been enshrined in the standards of the U.S. Sentencing Guidelines, the Principles of Prosecution of Business Organizations and countless other sources of federal judicial, law enforcement and regulatory guidance. However, the focus on compliance programs has shifted over time from being one of many important factors to increasingly being a threshold necessary to qualify for credit. The FCPA Corporate Enforcement Policy drives that point home. It requires implementation of an effective compliance and ethics program as part of the timely and appropriate remediation required to qualify for full credit under the policy, including:
- Ensuring there is a culture of compliance;
- Dedicating appropriate resources to compliance;
- Staffing the compliance function with personnel of adequate quality and experience;
- Providing the compliance function adequate authority and independence;
- Performing effective risk assessments;
- Compensating and promoting compliance personnel appropriately;
- Auditing to ensure effectiveness; and
- Implementing an appropriate reporting structure.
Individuals Remain in the Crosshairs: If anyone needed a reminder that the principles of the Yates Memo are alive and well within DOJ, the recent policy announcements should suffice. In reiterating what DOJ means by “full cooperation,” the FCPA Corporate Enforcement Policy provides, among other things, that corporations must:
- Disclose all relevant facts and attribute them to specific sources (where it would not violate attorney-client privilege) (i.e., no general narratives);
- Disclose all facts related to involvement in the misconduct by the company’s officers, employees or agents;
- Disclose all facts regarding potential misconduct by third-parties; and
- Do all of the above on a proactive basis.
Full Cooperation and Appropriate Remediation Means Full Cooperation and Appropriate Remediation: The FCPA Corporate Enforcement Policy makes explicit the extent to which companies will need to be detailed, fulsome and proactive in cooperating with DOJ in its investigations, and will need to take extensive and demonstrable steps — on a prompt basis — to remediate identified misconduct. The underlying concepts of what is outlined in the policy are familiar, but there is every reason to expect that DOJ will hold companies to a high standard in measuring satisfaction of these standards given the significant benefits being offered in the form of declination or significant penalty reductions.
DOJ Is Looking to Streamline ; In the announcements of these policies, Rosenstein and the other DOJ representatives have made repeated reference to efficiency and to effective allocation of DOJ resources. Although the proof will be in the pudding, DOJ seems to be signaling through the comments and the structure of these policies a desire to streamline enforcement matters, shorten the often extended multi-year timelines that have become a structural reality for complex white collar matters and thereby free prosecutorial resources for other enforcement priorities.

What This Means for Companies

Corporations that discover misconduct in their ranks never face easy decisions in the wake of that discovery, and these recent policy announcements will not alleviate that sting. However, for many they will offer a level of comfort and confidence by providing an increasingly clear and certain roadmap they can follow in investigating, remediating and disclosing the misconduct. Those companies best suited to take advantage of these policies will be the ones that study these policies now, and both internalize and operationalize the messages being sent. This is particularly true with respect to investment in and continuous improvement of compliance and ethics programs. This is the one area where corporations not currently under investigation have the most agency to control their fate in anticipation of (and in an effort to foreshorten, if not avoid) future investigations.

This article originally appeared in The FCPA Blog.

Enforcement and Prosecution Policy and Trends, Financial Institution Regulation May 2, 2018

No Changes to CFPB This Year

By Bill Mayberry, Joshua Davey and Joseph J. Reilly

In a statement on Thursday, April 26, a key House Republican on CFPB issues effectively admitted that despite his own efforts and those of the Trump Administration including Acting CFPB Director, Mick Mulvaney, Congress will almost certainly make no changes to the structure of the CFPB this year. As a result, there will probably be no change from a single-Director to a Commission, nor will changes be made to the way in which the CFPB is funded, or to the Director’s independent status.

In remarks to the U.S. Chamber of Commerce, Jeb Hensarling, Chairman of the House Financial Services Committee, conceded that he is now willing to accept the bi-partisan banking deregulatory bill that passed the Senate recently as S. 2155, which makes no changes to the CFPB’s structure. As we reported previously, several Senate Democrats who supported S. 2155 have made clear they would not accept amendments to it by the House that would weaken the CFPB.

Chairman Hensarling indicated that he would still like to pursue his CFPB reforms as separate bills, but most observers agree that if those reforms cannot be attached to the Senate bill, they will not become law this year. White House statements indicate that President Trump would like to sign S. 2155 into law by Memorial Day.

Enforcement and Prosecution Policy and Trends, Financial Institution Regulation April 20, 2018

Senate Votes to Strike Down Key CFPB Bulletin on Lending Discrimination in the Indirect Auto Market

By Bill Mayberry, Joshua Davey and Joseph J. Reilly

On Wednesday, the U.S. Senate voted almost entirely along party lines to invalidate, under the Congressional Review Act, the Consumer Financial Protection Bureau’s (CFPB) (in)famous 2013 Bulletin on lending discrimination in the indirect auto market via discretionary mark-ups and dealer compensation policies. The 2013 Bulletin, construing the Equal Credit Opportunity Act and its implementing rule, Regulation B, had served as the basis for a number of substantial CFPB enforcement actions against indirect auto lenders, with large fines and loud protests from industry.

The U.S. House of Representatives has been poised to vote down the 2013 Bulletin for some time, and is very likely to follow the Senate’s lead and make the invalidation effective. If as expected the House does act, this would mark the second time in the past year that Congress has voted to strike down a rule issued by the CFPB. (Last December, the Government Accountability Office’s General Counsel issued a formal legal opinion concluding that the 2013 Bulletin was, in fact, a “rule” subject to the Congressional Review Act, paving the way for yesterday’s Senate vote.) The first instance, of course, was Congress’ decision to invalidate the CFPB’s rule regarding arbitration.

Despite the Senate’s action Wednesday, efforts to weaken the CFPB by statute along the lines proposed by its Acting Director Mick Mulvaney and Republican congressmen continue to face challenges in Congress. While such proposals have passed and would likely easily pass again in the House of Representatives, no such measure was included in the recent package of reforms that passed the Senate with bipartisan support. Several of the Senate Democrats who voted for that package have indicated that they are not inclined to support measures that would weaken the CFPB structurally.

Enforcement and Prosecution Policy and Trends, Financial Institution Regulation, Securities and Commodities April 2, 2018

Does United States v. Ying Expand the Knowledge Requirement for “Classical” Insider Trading?

By Daniel A. Goldfried

On March 14, 2018, the SEC and DOJ sued Jun Ying, a former Chief Information Officer within an Equifax Inc. business unit, for insider trading. Specifically, they accused him of knowing about a significant Equifax data breach prior to its public disclosure and, while in possession of that material nonpublic information, exercising his Equifax options and selling those shares. When Equifax subsequently announced the data breach its stock price fell, giving Ying a loss avoided of over $117,000.

This fact pattern, were that all there is, seems a rather straightforward, uncontroversial application of the “classical” theory of insider trading. Under that theory, a corporate insider, such as Ying, violates Section 10(b) and SEC Rule 10b5 by trading in the company’s securities “on the basis” of material nonpublic information about the corporation. Chiarella v. United States, 445 U.S. 222, 230 (1980); United States v. Newman, 773 F.3d 438 (2d Cir. 2014) (abrogated on other grounds by Salman v. United States, 137 S. Ct. 420 (2016)). According to the SEC’s Rule 10b5-1, a trade is “made ‘on the basis of’ material non-public information . . . if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.” Rule 10b5-1(b) (emphasis added). To prove a criminal violation, the DOJ must also establish that the defendant acted “willfully,” 15 U.S.C. § 78ff(a), defined in this context as “a realization on the defendant’s part that he was doing a wrongful act under the securities laws.” Newman, 773 F.3d at 447 (quoting United States v. Cassese, 428 F.3d 92, 98 (2d Cir. 2005)).

However, here, both the SEC and DOJ acknowledge in their charging papers that, at the time of his trading, Ying was not “aware” of Experian’s data breach – at least not explicitly. Indeed, when he traded, Equifax had disclosed this information to only a select few insiders, of which Ying was not one. To the contrary, Equifax had explicitly lied to Ying and told him that the data breach he and his team were working on was for an Equifax client. As one of Equifax’s business lines is assisting clients with data breaches, this explanation seemed plausible. As time went on, however, the behavior of his superiors and colleagues made Ying suspicious that there was no “client” and that it was Equifax that had been breached. Based on his suspicions, Ying exercised his outstanding Equifax options and sold his shares.

But suspicions were all they were – Ying is alleged to have “put 2 and 2 together” according to the SEC’s Complaint. Indeed, Equifax did not reveal to Ying that it was the hacking victim until days later. Nevertheless, notwithstanding his avowed lack of actual knowledge, Ying was charged with criminal insider trading by the DOJ and sued civilly by the SEC.

Clearly the government believes that, notwithstanding his lack of actual knowledge, Ying’s strong suspicion that Equifax, and not a client, had suffered a data breach, is sufficient to satisfy the knowledge requirement of Rule 10b-5 and create insider trading liability. This expands Rule 10b5-1’s knowledge requirement beyond actual awareness and into the realm of constructive knowledge at best, and mere suspicion at worst.

Thus, as this case progresses, it will be interesting to see whether the facts show Ying had constructive knowledge of Equifax’s data breach or something less, and whether as a matter of law, whatever he “was aware of” at the time he traded, is deemed sufficient to create liability.

While we have not seen cases addressing whether actual, as opposed to constructive, knowledge is required in the classical insider trading context, under the “misappropriation theory” of insider trading, a tippee must have actual knowledge that a tipper received a personal benefit in connection with the disclosure of the material nonpublic information in order to be convicted of insider trading. United States v. Newman, 773 F.3d 438 (2d Cir. 2014) (reversing tippee criminal convictions because the government failed to prove the tippees had actual knowledge that the tipper received a personal benefit in connection with disclosure of the material nonpublic information). Absent actual knowledge of the personal benefit, there is no liability. Id. Given that a tippee can be quite removed from the actual insider who initially tipped the information, one can see how courts would be reluctant to impose anything other than an actual knowledge requirement for insider trading liability. For corporate insiders, however, a court may feel that constructive knowledge is sufficient given the unique information available to insiders that they can use to potentially piece together what is, in fact, material nonpublic information. Clearly this is the government’s view of what Ying did here. See, e.g., SEC Complaint at para. 33 (“Ying used the information entrusted to him as an Equifax employee to conclude that Equifax was the victim of the breach, and that the ‘breach opportunity’ idea suggesting a client was the victim was merely a cover story.”).

The battle lines are drawn. Stayed tuned to see how it is resolved.

Enforcement and Prosecution Policy and Trends March 22, 2018

Supreme Court Holds DOJ’s Feet to the Fire in Tax Crime Case

By Jonathan Marx

In Marinello v. United States, an opinion released yesterday, the Supreme Court adopted a narrowing interpretation of the tax code’s broadest criminal provision, the “tax obstruction” statute 26 U.S.C. § 7212(a). The Court’s opinion is good news for taxpayers, their advisors, and the sound administration of the law.

Marinello concerned whether the crime of “corruptly … endeavor[ing] to obstruct the due administration” of the tax laws (i) prohibits obstruction only of pending IRS audits and collection efforts, or (ii) instead applies more broadly. The government urged that the crime included conduct well before any IRS audit, so long as it was motivated by a desire to cheat on one’s taxes – including otherwise-lawful conduct like dealing in cash, or avoiding the creation of records not required by law.

DOJ urged a broad interpretation of the tax obstruction statute because the tax laws themselves are broad: tax administration is “continuous, ubiquitous, and universally known,” DOJ argued. But the Court correctly recognized that the breadth of the tax laws is itself a reason for caution, to avoid making every lapse in bookkeeping or business judgment a potential tax crime. And a person of ordinary moral sensibilities might recognize that (say) using cash or discarding receipts makes the IRS’s job harder. He might even realize some of these practices could invalidate a tax deduction, if he thought about it. But he would not believe such conduct to be a crime. On the government’s view, it could be – limited only by DOJ’s self-restraint.

Marinello wisely prohibits that result, requiring the government to prove the intent to obstruct a pending or foreseeable tax administration “proceeding” before it can obtain a § 7212(a) conviction. That “proceeding” must be something beyond processing tax returns and refunds, or other functions IRS performs in the background. In practice, Marinello means DOJ will charge tax obstruction only where obstructive conduct concerns some direct interaction between a taxpayer and an IRS employee – an audit, civil summons enforcement, dealings with the Appeals Office, enforced collection, Tax Court proceedings, or a tax crime investigation.

Off limits to DOJ going forward are tax obstruction charges based on pre-audit activities, like employing or promoting fraudulent tax shelters, or accounting misconduct. Of course, such conduct can still be prosecuted using the more traditional crimes like tax evasion, conspiracy, or filing false returns.

And that’s the main virtue of Marinello: holding the government to its burden of proof under the traditional tax crimes. DOJ’s pre-Marinello view (followed by most circuits until today) let the government salvage felony tax charges in failed tax evasion cases. Indeed, the primary effect of § 7212(a) in cases without a pending proceeding was to make tax obstruction a backstop felony charge when the defendant’s conduct looked like tax evasion, but the government could not prove a tax loss or the falsity of a document submitted under penalties of perjury. The broad view, in other words, made it easier for the government to charge felonies that should have been declinations or misdemeanors like failure to file.

Moreover, the broader view of § 7212(a) allowed the government to bring charges based on otherwise-legal conduct which did not directly threaten the integrity of the tax system, but merely risked doing so. Indeed, DOJ frequently used § 7212(a) to prosecute lawful conduct that, it contended, was rendered illegal by an intent to cheat on one’s taxes – actions like dealing in cash, as in Marinello, or using offshore banks or shell companies.

But there’s no reason for such a broad crime to exist. The DOJ has a valid prosecutorial interest in false returns and the underpayment of taxes. If a taxpayer intends for dealing in cash or other pre-“proceeding” conduct to result in underpaid taxes or false returns, the government should prosecute with the traditional tools at its disposal. But it should be compelled to pay the price those statutes require: proving an actual harm to the tax system via a false return or lost tax revenue. Otherwise-legal conduct several degrees removed from the government’s real interests should not be enough.

In other words, tax crimes are intended to protect the federal fisc and ensure the integrity of self-reporting. They do not create a general code of accounting or business ethics. No harm, no foul.

Marinello also answers the question of whether audit avoidance – tax planning intended to lower the audit profile of a client’s return or transaction – can, by itself, be tax obstruction. The answer is no, except in the exceedingly rare cases where a “proceeding” is already pending. But that answer provides only limited comfort, as DOJ can still pursue overly aggressive planning for clients under other statutes.

In sum, Marinello continued the Court’s recent trend of reining in DOJ’s interpretation of broadly worded white collar crimes. And it appropriately recognizes that prosecutorial discretion and mental state requirements are not reliable limits on criminal laws broad enough to reach innocent conduct. The net effect will be holding DOJ’s feet to the fire, deterring it from bringing cases that don’t provably implicate the core interests of tax enforcement.

Subject to Inquiry

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