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Government Investigations and White Collar Litigation Group
Enforcement and Prosecution Policy and Trends, Financial Institution Regulation, Securities and Commodities

SEC Charges Its First Robo Actions – Increasing Scrutiny of the Investment Platform

It was never a question of if, but rather, when the Securities and Exchange Commission would launch its first charges against robo-advisors and what those charges would be. Following then-SEC Chairperson, Mary Jo White’s keynote address at the SEC-Rock Center on Corporate Governance in 2016, regulators have been carefully monitoring robo-advisors’ compliance with the Investment Advisers Act of 1940 (“Advisers Act”).[1] In two recent Orders, the SEC found Wealthfront Advisers made false statements about its tax-loss harvesting program (“TLH”), and found Hedgeable made false performance comparisons about its investment performance. Both robo-advisors were also found to be in violation of the Advisers Act for their marketing use on social media platforms.

False Statement in Whitepaper Description

Wealthfront designed its TLH program to incentivize clients to sell certain assets at a loss to create tax benefits. On its website, Wealthfront provided whitepapers outlining the TLH program. However, from October 2012 through mid-May 2016, Wealthfront falsely stated in the TLH whitepaper that it monitored all client accounts to avoid any transactions that might trigger a wash sale, which prevents the tax benefit of the TLH program. (A wash sale occurs when an investor sells a security at a loss but within 30 days of the sale, buys the same or substantially identical security.) The SEC found Wealthfront did not in fact monitor all of its client accounts to prevent a wash sale prior to mid-May 2016. In fact, at least 31 percent of accounts enrolled in the TLH program experienced a wash sale. Ultimately, the failure to monitor for and prevent wash sales led to slightly lower returns: The average Wealthfront client received fewer tax losses, obtaining overall 5.6 percent in annual harvesting yield versus 5.8 percent. Despite the relatively minor impact on customers, the SEC fined the robo-advisor $250,000 for, among other things, violating Section 206(2) of the Advisers Act, which prohibits transactions or business practices that operate as a fraud or deceit upon clients or prospective clients.

Misleading Advertising and Marketing Materials

A second robo-advisor, Hedgeable, was sanctioned for its misleading marketing through the use of its “Robo Index” created to compare the performance of Hedgeable, to other unaffiliated robo-advisors. Hedgeable’s misrepresentations were egregious. Featured on its website, the index incorrectly illustrated Hedgeable’s returns by failing to account for over 96 percent of Hedgeable’s clients in its calculations. Hedgeable failed to use actual performance data and various other risk factors when depicting the average returns for the comparison robo-advisors, thereby providing incorrect return projections for its competition robo-advisors.

The SEC also found Hedgeable’s online fact sheets to be misleading. The annual benchmark returns were not updated for certain years, leading clients to believe the model portfolio outperformed its benchmark greater than what actually occurred. Hedgeable also incorrectly calculated certain benchmark and portfolio returns for several ETFs in violation of Section 206(2) and Section 206(4) of the Adviser Act.

Compliance of Social Media Usage

Under Section 206(4) of the Advisers Act, it is “unlawful for any investment adviser…to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.” The SEC has made clear that these requirements are applicable to robo-advisors. Publishing, circulating, or distributing any advertisement that directly or indirectly provides a testimonial concerning the investment adviser that “contains any untrue statement of a material fact or which is otherwise false or misleading” is a violation of Rule 206(4)-1.

In addition to its findings with respect to Wealthfront’s TLH whitepapers, the SEC also found Wealthfront, willfully violated Section 206(4) of the Advisers Act and Rules 206(4)-1 by selectively republishing (“retweeting”) certain posts by other Twitter users that constituted positive testimonials about Wealthfront’s services. In some cases, Wealthfront knew or should have known that the Twitter users providing positive reviews had an economic interest in promoting Wealthfront, and Wealthfront failed to disclose the conflict of interest in violation of Rule 206(4)-3. These charges come as no surprise, following the SEC’s sanctions in July 2018 against two investment advisers and three investment adviser representatives for similar violations of Section 206(4) for soliciting, and publishing client testimonials on its various websites including Yelp and Facebook.

Similarly, the SEC found Hedgeable was in violation of Section 206(4) and the rules thereunder, for marketing false and misleading information on its “Robo-Index” through social media as well as its website.

Further, neither robo-advisor adopted and designed written policies and procedures with a scope that included certain social media usage in its compliance review of marketing materials and communications as required by Rule 206(4)-7.

Bottom Line

Ultimately, the SEC charged both robo-advisors with violations of the Advisers Act and required them to pay a fine. In addition, Wealthfront is required to notify its advisory clients of the Order and provide a copy of the Order to clients by January 20, 2019.[2] While, these Orders were not unique issues to robo-advisors, they serve as a reminder that the Advisers Act and its rules apply to robo-advisors. In fact, these Orders indicate that since robo-advisors are only available on electronic platforms, they may be more susceptible to misleading online marketing and social media ploys. Robo-advisors, therefore, should examine their compliance and supervision policies to ensure truthful and accurate data is being provided to clients, as well as ensuring social media platforms are being adequately monitored.

McGuireWoods’ experienced broker-dealer/investment adviser team will continue to monitor and report on important regulatory compliance updates. For more information, contact the authors of this article or any member of the team.

[1] See Financial Industry Regulatory Authority (FINRA) Report on Digital Investment Advice https://www.finra.org/sites/default/files/digital-investment-advice-report.pdf (2016). For state registered advisers, see, Massachusetts Securities Division Policy Statements: State-Registered Investment Advisers’ Use of Third-Party Robo-Advisers( http://www.sec.state.ma.us/sct/sctpdf/Policy-Statement-State-Registered-Investment-Advisers-Use-of-Third-Party-Robo-Advisers.pdf) and Robo-Advisers and State Investment Adviser Registration (April 1, 2016) (http://www.sec.state.ma.us/sct/sctpdf/Policy-Statement–Robo-Advisers-and-State-Investment-Adviser-Registration.pdf).

 

[2] Hedgeable was not also required to send its Order to advisory clients, which is most likely because the firm, as noted in the Order, is winding down its business and no longer meets the requirements to be an SEC registered adviser. Furthermore, Hedgeable is paying a significantly reduced penalty, as compared to Wealthfront, and has a payment plan, both factors indicative of reduced assets.

Financial Institution Regulation

FINRA’s 2018 Report on Cybersecurity Practices – Preventing “Spear Phishing” and “Whaling” Attacks

This article was originally posted on our sister publication, Password Protected.

On December 20, 2018, the Financial Industry Regulatory Authority (FINRA) released a report on cybersecurity practices for broker-dealers. Today’s post is the second in a series of summaries sharing essential, timely insight on how these practices impact your business. Please click here for the first post on cybersecurity practice impacts.

FINRA names “phishing” attacks as one of the most common cybersecurity threats raised by firms with the self-regulator. The goal of a phishing email is to manipulate the recipient into taking action. FINRA focuses on two types of phishing attacks in the report. The first is “spear phishing,” where the sender researches and targets the recipient(s) with a customized approach designed to get confidential information from the individual(s). The second is “whaling,” wherein the hacker sends targeted emails impersonating senior executives at the firm in order to set action in motion, typically wiring funds to specifically identified accounts.

There is no doubt that “spear phishing” and “whaling” are very real threats to financial institutions today. As the Securities & Exchange Commission (SEC) detailed in a recent investigation report, the FBI estimates that “’business email compromises’ have caused over $5 billion in losses since 2013, with an additional $675 million in adjusted losses in 2017 – the highest estimated out-of-pocket losses from any class of cyber-facilitated crime during this period.’”

While the SEC’s 21(a) Report focuses on risk and controls for public companies, the financial services industry, even the non-public company segment of the industry, faces the same risk and similar regulator expectations and requirements of effective controls to protect customer and firm information and assets. The SEC found that emails sent to firm staff from “fake” firm executives or vendors requested funds be wired to specified accounts. Employees at nine companies fell for the spoofed emails and, together, the issuers lost nearly $100 million.

The SEC’s 21(a) Report found that the schemes were “not sophisticated in design or the use of technology: instead they relied on … weaknesses in policies and procedures and human vulnerabilities that rendered the control environment ineffective.”

The phishing segment of FINRA’s Cybersecurity Report conveys information on two topics: (1) how they do it (what to watch for — sources and types of communications) and (2) suggested best practices to combat the threat.

On the “how they do it front,” FINRA details the different types of senders (entities and individuals), as well as the typical characteristics of phishing emails. Further, the Report, recognizing the increasing sophistication of such attacks, also details several different characteristics, as well as examples, of phishing communications. Whether the phisher is seeking customer personal identifiable information or fraudulent wire transfers, if firms develop policies and procedures and focus training on the types of senders (or hackers/phishers) to watch out for and the typical variations of such communications, this will mitigate risk that of employees falling victim to the scams.

Importantly, FINRA’s Report details a dozen best practices implemented by firms to combat the phishing threat. While we commend the review of the full list of best practices to firms, we wanted to emphasize four of the recommended effective practices.

  • Creating policies and procedures that address phishing practices including identifying such emails, what to do when such emails are suspected (e.g., do not click on links, notify technology and compliance, confirming wire transfers, etc.).
  • Establishing robust confirmation policies and procedures for executing transaction requests.
  • Periodic, mandatory training of employees and associated persons on phishing practices and policies and procedures for disseminating information. Training allows the firm to provide updates on new phishing tactics and remind everyone of the specifics of the anti-phishing policies and procedures as well as the risks to customers and the firm of noncompliance.
  • Developing remedial training and imposing consequences for those who repeatedly violate firm phishing protocols. Impressing the importance of everyone’s adherence to firm policies and procedures in this area is one way to close potential gaps that hackers can exploit. This includes following up when the firm is on notice of individuals who violate the policies.

These effective or best practices are similar to those highlighted in the SEC’s 21(a) Report. For example, the SEC ultimately concluded that, while the companies involved in the matter had implemented policies and procedures and training, “weaknesses in the policies and procedures and human vulnerabilities” needed to be factored into the development of controls specifically geared to cyber threats. The SEC emphasized the need to reassess internal controls through the lens of cyber-security threats. While it is always best if that reassessment can occur in advance of a cyber-event, at a minimum, taking steps to shore up payment authorization and verification requirements and enhance training after an event, as the issuers investigated by the SEC staff did, is imperative to protect customers and the firm.

Finally, FINRA, recognizing that successful attacks may start with the customers, recommends that firms also educate their customers and direct them to resources that help them protect themselves.

FINRA’s Report provides comprehensive information for firms to combat cyber-related frauds. While the scammers continue to alter their tactics and increase the sophistication of the scams, implementing internal controls and effective policies and procedures that stay ahead of the scams and implementing effective training provide important risk mitigation strategies.

Enforcement and Prosecution Policy and Trends

DOJ Loosens Yates Memo Requirements For Corporate Cooperation Credit

Yesterday, Deputy Attorney General Rod Rosenstein announced a series of changes to Department of Justice (DOJ) policy that clarified DOJ’s expectations for cooperation in investigations of corporate wrongdoing. The changes are sensible and should be welcomed by the business community as an improvement over the prior policy, commonly known as the Yates Memo.

As Rosenstein noted, the changes are intended to recognize how the Yates Memo has been applied on the ground, at least in many cases. Even so, the changes should provide companies with greater comfort in several respects.

Under the revised policy, corporations are now expected to identify individuals who were “substantially involved” in or responsible for the underlying misconduct. Whereas the Yates memo, at least on paper, required the cooperating company to identify for the government every individual in the organization involved in the misconduct – no matter their role in the organization or in the misconduct, before a settlement could be finalized. To be sure, that requirement was sometimes honored in the breach. But in combination, the threat of withheld cooperation credit on an all or nothing basis, plus the requirement that all potentially culpable individuals be identified before a settlement could be finalized, gave the government significant leverage to demand that target companies bend to the prosecutors’ view of the world about individual employees’ culpability. For companies, this dynamic sometimes created pressure to err on the side of over-inclusion in designating culpable individuals.

That pressure has not gone away, but it is lessened. The revised policy is an attempt, as Rosenstein recognized, to conserve resources – both for the government and the company involved – and prevent unnecessary delay in resolving corporate liability. For companies under investigation, this change may help to reduce the significant time and cost required to conduct an investigation deemed sufficient for cooperation credit. Now, if the government team disagrees with a target company about which employees are culpable and to what degree, the government attorneys have discretion to recommend partial cooperation credit as part of a settlement. More importantly, that discretion now exists as official DOJ policy, and not just an informal deviation from the rule.

Rosenstein also reported similar changes in civil cases. The new policy provides that corporate cooperation credit in civil cases can be awarded on a sliding scale – it need not be all or nothing. And in prepared remarks accompanying the rollout of the changes, Rosenstein noted that cooperation credit can still be awarded, in appropriate cases, where a company assists the government’s investigation, but the parties cannot reach agreement about the identity or culpability of every line employee potentially involved in misconduct. (Senior employees are different – as before, the company must identify all wrongdoers in senior management to receive any cooperation credit.)

All else equal, the changes modestly strengthen the hand of companies who sincerely seek to cooperate with the government to resolve investigations, but cannot reach agreement with the government over the role of particular individual employees in corporate misconduct. Companies now have a little bit more leeway to “agree to disagree” with the government about the status of lower-level employees while retaining the benefits of cooperation. Before, such a disagreement was (at least in principle) fatal to a successful settlement. Now it need not be. And that’s unquestionably a salutary development.

Energy Enforcement

Lessons From FERC Staff Reversal In Footprint Power

This post recently appeared in Law360, available for subscribers here.

Anyone practicing in the Federal Energy Regulatory Commission enforcement arena should sit up and take notice of the recent developments in the Footprint case at FERC. The most public step in an enforcement procedure before FERC is the issuance of an order to show cause, or OSC, by the commission. An OSC is FERC’s formal announcement that its Office of Enforcement, or OE, staff has found the respondent to have committed statutory or regulatory violations. The OSC includes a report from OE reciting the facts that support such a conclusion, as well as any recommended civil penalty and disgorgement amount.

The OSC invites the respondent to “show cause” why it should not be penalized. This OSC is usually followed by an answer filed by the respondent, which is typically followed by a reply brief from OE. From the inception of the OSC process in 2007, FERC has never found cause for not imposing a penalty to have been shown, giving OE a perfect track record in OSC proceedings of obtaining a final FERC order that adopted OE’s position.

That streak may end in light of an unusual filing by OE staff on Sept. 19, 2018, when OE recommended that FERC drop its case against Footprint Power LLC.[1] Footprint operates the Salem Harbor Station in Salem, Massachusetts, which provides generation to the ISO-New England electricity market.

Briefly stated, OE alleged that Footprint had not maintained sufficient fuel reserves to run its oil-fueled generation unit at the output level at which it had offered into the day-ahead market. OE claimed that these offers were therefore false and misleading, in violation of several commission rules, because, according to OE, the plant could not run at the levels at which it had offered.

In its answer, Footprint raised several arguments related to the methods by which OE calculated the amount of available fuel, including an argument that OE had not taken into account the start-up time required for the unit to reach full generating capacity. Footprint argued that during this start-up period, the unit burned less fuel, and thus the unit did have sufficient fuel to meet its obligations during the period under review — and that ISO-NE knew this.

In its reply brief, OE accepted this “new” argument regarding the start-up period, reconsidered the fuel volume and concluded that Footprint had not violated the applicable rules for all but a few days during the period under review.

We note that in its answer, Footprint characterized the start-up argument as having been made in prior nonpublic submissions and having been discussed in a deposition. Yet in its reply, OE characterized this argument as being made for the first time in Footprint’s answer. Upon reconsidering the evidence and arguments presented, OE recommended vacatur — essentially the complete withdrawal — of the entire OSC, having determined that further pursuit of the case would not be a “prudent use of Staff’s resources.”

Notably, OE made a point of only accepting Footprint’s argument regarding the start-up time and related fuel use — explicitly rejecting Footprint’s other arguments related to emissions limits, the statute of limitations and whether ISO-NE was actually misled by the offers.

At this time, the commission has not yet issued a final order, so it is possible that it will decide to issue an order assessing civil penalties against Footprint for the one week in which the start-up argument did not apply. However, we believe it is more likely that the commission will follow OE’s recommendation and drop the case.

While it is tempting to so conclude, we do not think this is a signal of any general enforcement retrenchment on the part of OE, nor of any influence on the part of the new members of the commission prodding OE to be more industry-friendly.

For starters, unless someone violated commission ex parte communications and separation of functions rules (which we doubt), the OE change in position could not have originated from direct commission intervention. This is because the staff making the recommendation should not have been in contact with any commissioners about the matter. Instead, we think the change in direction in Footprint came from the so-called “non-decisional” staff within OE, who are “walled off” from the commissioners and who would have had to further litigate the case if Footprint did not pay any penalty assessed.

On some level, OE’s reconsideration of the facts and merits of Footprint’s arguments is necessarily specific to this case, and not readily transferable to other fact patterns. OE’s reply puts great emphasis on the compelling — and “new” — factual argument made by Footprint. Faced with this new presentation of the compelling facts in Footprint’s answer, OE staff may have simply reconsidered issues of prosecutorial discretion and concluded that if they were to have proceeded to litigate in federal court, they would likely lose.

But there may be more in play than just a reconsideration of the facts and the merits. This recommendation may also be an effort by OE to appear fair and reasonable in the face of criticism that the OSC process has become a guaranteed win for OE and the commission. By accepting a compelling fact-based argument here, OE may be seeking to bolster the importance and appearance of fairness of the OSC process, pushing back against calls from some to skip a heretofore seemingly “rubber stamp” OSC process altogether and move straight to litigation of such cases in federal district court.

Furthermore, this result may be an effort to beat back arguments in the federal courts that the OSC process is not meaningful — which matters when courts are confronted with defense arguments relating to statutes of limitations, the nature of de novo review under the Federal Power Act and other matters that could affect the scope of FERC’s authority.

One lesson for respondents is to make every argument you can at every stage, and to never stop making arguments in which you believe. An argument may be initially dismissed by OE, or simply buried within a lengthy brief filed early in the investigation. OE’s position suggests that, in its view, had Footprint put greater emphasis on the start-up argument from the outset of the investigation, it may have been able to avoid the order to show cause stage. But because it apparently did not, at least from OE’s perspective, it is now clear that once these new or forgotten arguments are aired in a different forum, such as with the commission, or in a public way, they can take on more significance.

A second lesson stems from prior claims in other cases by OE, and even the commission, that have dismissed arguments in OSC proceedings or in court cases because they were supposedly not advanced during the investigation phase and therefore, in their view, were after-the-fact inventions. After Footprint, OE will be hard-pressed to ignore or discount an argument or evidence simply because it was truly made for the first time in a respondent’s answer to order to show cause or at another stage.

A final lesson relates to the possibility that in the past, parties responding to an OSC who desired to move quickly on to a de novo proceeding in federal court may have considered de-emphasizing certain arguments in order to focus their presentation or just save on litigation costs. They may also have considered not submitting additional evidence at the commission level that was not sought or submitted in the investigation phase, thus “saving” it for the federal court.

This might be based on the belief that the material would be “wasted” in the seemingly fait accompli OSC process, and would merely educate the OE staff on the respondent’s litigation strategy. Setting aside whether this approach may risk a “waiver” argument by OE (later, in court), OE’s reply in Footprint challenges the wisdom of this approach on the merits. The reply suggests that OE may — and in some cases will — change its mind when presented with the right argument (or at least fears that the commission may do so on its own).

[1] Reply of Enforcement Litigation Staff to the Answer of Footprint Power LLC and Footprint Salem Harbor Operations LLC and Recommendation to Vacate Order to Show Cause, Footprint Power LLC, FERC Docket No. IN18-7-000 (Sep. 19, 2018).

Financial Institution Regulation

CFPB Signals Potential for Fair Lending Rulemaking

This post recently appeared in our sister publication, Consumer FinSights.

In its recently published Fall 2018 Rulemaking Agenda, the Bureau of Consumer Financial Protection announced that it is considering future rulemaking activity regarding the requirements of the Equal Credit Opportunity Act (“ECOA”) – specifically, “concerning the disparate impact doctrine in light of recent Supreme Court case law and the Congressional disapproval of a prior Bureau bulletin concerning indirect auto lender compliance with ECOA and its implementing regulations.”

In May, President Trump signed a joint resolution passed by Congress disapproving the Bureau’s March 21, 2013 Bulletin titled “Indirect Auto Lending and Compliance with the Equal Credit Opportunity Act.” The Bulletin’s purpose was to “provide[] guidance for indirect auto lenders within the Bureau’s jurisdiction on ways to limit fair lending risk under the ECOA.” The Bulletin had been controversial from the start, suggesting that indirect auto lenders — who purchase and service loans made by auto dealers that fit criteria agreed to between the dealer and lender — consider imposing controls on dealer markup and eliminate the dealer’s discretion to markup buy rates.

Acting Bureau Director Mick Mulvaney praised the congressional resolution, continuing the Bureau’s move away from the fair lending enforcement priorities of the Bureau’s first Director, Richard Cordray (who, as an aside, was just defeated this past Election Day as the Democratic nominee for Governor of Ohio). Mulvaney thanked President Trump and Congress “for reaffirming that the Bureau lacks the power to act outside of federal statutes.” Mulvaney also referred to the Bulletin as an “instance of Bureau overreach,” and asserted that the initiative “seemed like a solution in search of a problem.” He indicated then that Bureau rulemaking on disparate impact would reflect another theme of his approach: a move toward formal rulemaking in lieu of bulletin issuance or “regulation by enforcement.”

Although the Bureau’s Rulemaking Agenda does not address the details of the contemplated rulemaking activity around ECOA, the Agenda’s reference to “recent Supreme Court case law” suggests that any rulemaking may be designed to address unanswered questions following the Supreme Court’s 2015 decision in Tex. Dep’t of Housing & Community Aff. v. Inclusive Communities Project, Inc., 135 S. Ct. 2507 (2015), in which the Court upheld the concept of disparate impact liability under the other principal federal lending discrimination law, the Fair Housing Act, but also emphasized that disparate impact litigants must prove causation – in other words, proof of a statistical disparity among racial groups alone is not sufficient. Inclusive Communities also imposed other restrictions on disparate impact liability.

Potential Bureau rulemaking might focus on application of the Court’s holdings to ECOA. Such a rule would be more durable than the Bureau’s earlier fair lending bulletin, remaining in effect unless altered by later rulemaking (and thus surviving any future leadership change at the Bureau). A rule would also be binding on other federal agencies and the courts, and thus could provide much-desired clarity for lenders.

 

Financial Institution Regulation

California Passes Small Business Truth-in-Lending Law

This post originally appeared on our sister publication Consumer FinSights

On September 30, 2018, California enacted the nation’s first small business truth-in-lending law when Governor Jerry Brown signed into law SB 1235. The law aims to protect small businesses from predatory lending practices by requiring increased transparency of certain business-purpose loans marketed to small businesses.

SB 1235 draws comparisons to the federal Truth in Lending Act, which imposes disclosure requirements for consumer-purpose, but not business-purpose loans.  SB 1235 covers “commercial financing,” defined to include commercial loans, commercial open-end credit plans, factoring, and merchant cash advances, for transactions less than $500,000.  Of note, SB 1235 applies to nondepository institutions, such as an “online lending platform,” and exempts traditional depository institutions.

Disclosures required by the law include: (i) the total amount of funds provided, (ii) the total dollar cost of the financing, (iii) the term or estimated term, (iv) the method, frequency, and amount of payments, (v) the description of prepayment policies, and (vi) the annualized rate of the total cost of financing. The California Department of Business Oversight (DBO) is tasked with developing regulations to clarify the ambiguous scope of SB 1235.

The law has garnered broad industry support from signatories to the Small Business Borrowers’ Bill of Rights, which encompasses small business lenders, fintech companies, advocacy groups, and community organizations. Some business groups, including the Commercial Finance Association and Electronic Transactions Association, have chosen not to support the bill.

 

 

Enforcement and Prosecution Policy and Trends

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

Second Circuit Clarifies Limits of FCPA’s Extraterritorial Reach

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

Implications of Judge Kavanaugh’s Nomination for Criminal Sentencing

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

Supreme Court Narrows Ability to Recover Internal Investigation Costs

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.

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