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Investment Management Legal and Regulatory Update - October 2015

October 2015

Latest Developments

SEC Reaches First Distribution in Guise Settlement

In keeping with its enforcement efforts to ramp up investigations into fees for distribution in guise, the SEC charged First Eagle Investment Management, investment adviser to the First Eagle Funds, and its affiliated distributor, FEF Distributors, LLC, with violating Section 206(2) of the Advisers Act and Section 34(b) of the Investment Company Act and causing the funds to violate Section 12(b) of the Investment Company Act and Rule 12b-1 thereunder. Without admitting or denying the findings, First Eagle and FEF Distributors agreed to pay $24.9 million in disgorgement, $2.3 million in pre-judgment interest, and a $12.5 million civil monetary penalty, totaling nearly $40 million. The SEC stated that money would be returned to the accounts of affected shareholders.

The core of the distribution in guise enforcement effort, undertaken two years ago, lies in the SEC’s suspicions that fund complexes are paying distributors more than Rule 12b-1 allows by setting up false sub-transfer agency (sub-TA) arrangements between funds and distributors. According to the SEC, this was exactly the situation with First Eagle and FEF Distributors.

According to the order, from January 2008 through March 2014, First Eagle and FEF Distributors improperly treated agreements with two intermediaries as agreements for sub-TA services, when they should have been categorized as marketing and distribution under the funds’ Rule 12b-1 plan. This improper categorization resulted in approximately $25 million of fund assets being used to pay for distribution and marketing services outside of the Rule 12b-1 plan. These payments were in addition to payments made to the two intermediaries pursuant to the Rule 12b-1 plan.

The First Eagle action involved three services agreements (a Financial Services Agreement, a Selected Dealer Agreement, and a Correspondent Marketing Program Participation Agreement (CMPPA)) with two intermediaries (identified as Intermediary One and Intermediary Two in the order).

Under the Financial Services Agreement, Intermediary One was to provide sub-TA services typically paid for out of fund assets, including:

  • maintaining separate records for each customer in an omnibus account for each fund;
  • transmitting purchase and redemption orders to the funds;
  • preparing and transmitting account statements for each customer;
  • transmitting proxy statements, periodic reports, and other communications to customers;
  • providing periodic reports to the funds to enable each fund to comply with state blue sky requirements; and
  • providing standard monthly contingent deferred sales charge reports.

In exchange for providing these services, Intermediary One charged per-account fees ranging from $16-$19.

Under the Selected Dealer Agreement, Intermediary One was “invited to become a selected dealer to distribute shares of the [funds].” (emphasis added by the SEC) The agreement described the services to be provided, including “due diligence, legal review, training, [and] marketing,” along with the following fees, which the agreement stated were in addition to Rule 12b-1 fees paid to Intermediary One:

  • a one-time fee of $50,000;
  • 25 basis points of total new gross sales of shares of any class sold by Intermediary One, paid monthly; and
  • 10 basis points of the value of fund shares sold by Intermediary One that are held for more than one year, payable quarterly (“for our continuing due diligence, training and marketing”).

First Eagle and FEF Distributors caused the funds to pay total fees of $24.6 million to Intermediary One pursuant to the Selected Dealer Agreement. The SEC found that the services to be provided under the Selected Dealer Agreement were generally marketing and distribution, not sub-TA services. As a result, First Eagle and FEF Distributors were prohibited from using fund assets to make payments to Intermediary One under the Selected Dealer Agreement, unless such payments were made pursuant to the written, approved Rule 12b-1 Plan (which they were not).

Under the CMPPA, Intermediary Two agreed to:

  • provide email distribution lists of correspondent broker-dealers that have requested “sales and marketing concepts” from Intermediary Two;
  • market the funds on its internal website;
  • invite the funds to participate in special marketing promotions and offerings to correspondent broker-dealers;
  • invite First Eagle to participate in Intermediary Two’s annual conference;
  • provide quarterly statements detailing which correspondent broker-dealers are selling the funds; and
  • waive all trading fees charged to correspondent broker-dealers relating to the funds.

In exchange for providing these services, Intermediary Two charged an annual fee equal to 5 basis points of the net asset value of outstanding shares of the funds sold by Intermediary Two, billed quarterly. First Eagle and FEF Distributors caused the funds to pay approximately $290,000 to Intermediary Two pursuant to the CMPPA. The SEC found that, as with the Selected Dealer Agreement, the above services were generally marketing and distribution services, not sub-TA services. As a result, First Eagle and FEF Distributors were prohibited from using fund assets to make payments to Intermediary Two under the CMPPA, unless such payments were made pursuant to the written, approved Rule 12b-1 Plan (which they were not).

The SEC further found that First Eagle inaccurately reported to the funds’ boards that the distribution and marketing fees paid to the intermediaries under the Selected Dealer Agreement and the CMPPA were sub-TA fees. In 2008, First Eagle engaged outside counsel to review its practices with regard to payments for sub-TA services. First Eagle shared the results of that review with the board in a report which indicated that all of the fees paid to Intermediary One and Intermediary Two under the Financial Services Agreement, the Selected Dealer Agreement and the CMPPA were for sub-TA services. In addition, the SEC found that the funds’ prospectus inaccurately disclosed that “FEF Distributors or its affiliates bear distribution expenses to the extent they are not covered by payments under the [Rule 12b-1] Plans,” when, in reality, the funds bore the additional distribution and marketing expenses in connection with the Select Dealer Agreement and the CMPPA.

Julie Riewe, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, noted “[m]utual fund advisers have a fiduciary duty to manage the conflict of interest associated with fund distribution, namely whether to use their own assets or to recommend to their fund’s board to use the fund’s assets to distribute shares.” She observed that “First Eagle breached that fiduciary duty by using the funds’ assets rather than its own money to pay for distribution and failed to provide accurate information to the funds’ boards.”

Andrew J. Ceresney, Director of the SEC’s Enforcement Division, echoed Ms. Riewe’s comments, stating “First Eagle and FEF inappropriately used money belonging to the shareholders of the funds to pay for services clearly intended to market the funds and distribute their shares. Unless part of a 12b-1 plan, the firm should bear those costs, not the shareholders.”

The SEC hinted that the civil monetary penalty generally may have been higher, except First Eagle and FEF Distributors cooperated with the staff and undertook remedial efforts, including:

  • First Eagle immediately began to make payments under the Selected Dealer Agreement and the CMPPA from its own revenues;
  • First Eagle ceased using the funds’ assets to make any portion of such payments; and
  • First Eagle offered to return the amount of money improperly paid from the funds’ assets.

While the First Eagle order is certainly illuminating as to what types of activities the distribution in guise enforcement initiative will be scrutinizing, questions remain. For example, the order fails to explain the line between what is marketing and distribution and what is shareholder servicing in the Selected Dealer Agreement. This, combined with the fact that intermediary agreements with funds are often numerous and varied, makes board oversight particularly difficult.  Boards do not typically review each intermediary agreement and often rely on investment advisers to negotiate them. Some in the industry are hoping for clarification through regulation so as to avoid the pitfalls associated with regulation through enforcement actions.

The SEC made it clear in its press release relating to the enforcement order that while the First Eagle enforcement action may be the first of its kind, it will likely not be the last.

Sources: In the Matter of First Eagle Investment Management, LLC and FEF Distributors, LLC, Investment Company Act Release No. 31832 (September 21, 2015), available here; Greg Saitz and Whitney Curry Wimbish, “First Firm Whacked in Distribution in Guise Investigation,” Board IQ, September 21, 2015; SEC Charges Investment Adviser with Improperly Using Mutual Fund Assets to Pay Distribution Fees, SEC Press Release 2015-198 (September 21, 2015), available here.

SEC Proposes New Rules for Liquidity Management, “Swing Pricing”

On September 22, 2015, the SEC announced a proposal for a package of rule reforms aimed at enhancing effective liquidity risk management. The reforms—in particular, proposed Rule 22e-4—would require funds to establish “liquidity risk management programs,” increase disclosure regarding the liquidity of fund assets, and give funds the ability to use “swing pricing” in times of increased purchase and/or redemption activity.

According to SEC Chair Mary Jo White, “Promoting stronger liquidity risk management is essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds. These significant reforms would require funds to better manage their liquidity risks, give them new tools to meet that requirement, and enhance the Commission’s oversight.”

The proposal’s new rules and requirements are summarized below, along with the proposed “swing pricing” option.

Liquidity Risk Management Program
Proposed Rule 22e-4 would require mutual funds (except money market funds) and ETFs to implement a liquidity risk management program, which includes the following elements:

  • Classification of the liquidity of fund portfolio assets. Portfolio assets would be classified into six categories based on the number of days it would take to liquidate assets without materially affecting the asset’s value immediately prior to sale.
  • Assessment, periodic review and management of a fund’s liquidity risk. The rule would define liquidity risk as “the risk that a fund could not meet redemption requests that are expected under normal conditions or under stressed conditions, without materially affecting the fund’s NAV per share.”
  • Codification of 15% liquidity guideline. Rule 22e-4 would codify the 15% limit on illiquid assets included in the current SEC guidelines.
  • Establishment of a three-day liquid asset minimum. Funds would be required to determine a minimum percentage of net assets that must be invested in cash and assets that can be liquidated within three business days without materially affecting the value of the assets immediately prior to sale.
  • Board approval and review. Board approval and annual review of the liquidity risk management program and three-day liquid asset minimum would be required. This would include an annual review of a written report outlining the program’s adequacy, provided by the fund’s investment adviser.

Disclosure and Reporting
The proposed rule would also include additional disclosure and reporting requirements related to liquidity and a fund’s use of swing pricing (discussed below). These requirements include:

  • Disclosure of any agreements for bank lines of credit. Funds would be required to file agreements related to lines of credit.  
  • Disclosure of the liquidity classifications of assets. This disclosure would be made in the proposed Form N-PORT.
  • Disclosure of the three-day liquid asset minimum. This disclosure would be made in the proposed Form N-PORT.
  • Disclosure of the use of swing pricing and the methods used to meet redemptions. This disclosure would be made in the financial highlights section of a fund’s financial statements.
  • Disclosure of information about committed lines of credit, interfund lending and swing pricing. This disclosure would be made in the proposed Form N-CEN.
  • For ETFs only, disclosure regarding whether an authorized participant is required to post collateral in connection with the purchase or redemption of shares. This disclosure would be made in the proposed Form N-CEN.

“Swing Pricing”
The SEC will consider proposed amendments to Rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use “swing pricing” during times of heightened purchase or redemption activity. The SEC explains that swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders. It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks.

A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV, known as the swing threshold. The proposed amendments include factors that funds would be required to consider to determine the swing factor and swing threshold, and to annually review the swing threshold. The fund’s board, including the independent directors, would be required to approve the fund’s swing pricing policies and procedures.

This optional pricing system would be aimed at diminishing the impact of increased purchases or redemptions on shareholders who choose to hold, rather than redeem, their fund shares. Comments are due within 90 days of the publication of the proposal in the Federal Register (to date, it has not been published).

While all five commissioners supported the rule proposal as a whole, there remained lingering doubts for some. Commissioner Daniel Gallagher (who has since resigned effective October 2, 2015) voiced concerns over the “one-size-fits-all” approach of the three-day liquid asset minimum, citing varying redemption window requirements under the Securities Exchange Act. He also observed that, for funds that adopt swing pricing, where a large institutional investor’s trading may trigger the swing pricing model, retail investors who make smaller trades on the same day will be burdened with the pricing consequences of the institutional investors’ trading activity.

Sources: Open-End Fund Liquidity Risk Management Programs; Swing Pricing, Release No. IC-31835 (September 22, 2015, available here; SEC Proposes Liquidity Management Rules for Mutual Funds and ETFs, SEC Press Release 2015-201 (September 22, 2015), available here; Daniel M. Gallagher, Statement on Open-End Fund Liquidity Risk Management Programs and Swing Pricing (September 22, 2015), available here; Beagan Wilcox Volz, “SEC Targets Liquidity Risk with Sweeping Rule Proposal, Ignites, September 23, 2015; ICI Memorandum “SEC Issues Liquidity Risk Management Proposal for Open-End Funds” (September 28, 2015).

Additional Rule Proposals, Rule Adoptions and Guidance

FinCEN Proposes Rule Requiring AML Programs for Investment Advisers

The Financial Crimes Enforcement Network (FinCEN) has proposed a rule, enforceable by the SEC, that would require SEC-registered investment advisers to establish anti-money laundering (AML) programs and file suspicious activity reports (SARs).  In addition, the proposed rule would broaden the definition of “financial institution” to include investment advisers in rules implementing the Bank Secrecy Act (BSA). Thus, investment advisers would be subject to some BSA requirements formerly applicable only to financial institutions. Key examples include the requirement to file Currency Transaction Reports, as well as to keep records relating to the transmittal of funds. FinCEN believes that as long as investment advisers are not subject to AML program and SAR requirements, money launderers may see them as a low risk way to enter the U.S. financial system. Comments on the proposed rule must be submitted by November 2, 2015.

FinCEN is not, at this time, proposing customer identification programs for investment advisers, nor is it including in its AML proposal a requirement to adopt customer due diligence requirements recently proposed for other financial institutions. However, in its proposal, FinCEN stated that it anticipates addressing both of these issues in subsequent rulemakings, with the issue of customer identification program requirements anticipated to be addressed via a joint rulemaking effort with the SEC. Mutual funds are already required to establish AML and customer identification programs and file SARs, as are broker-dealers.

Source: Anti-Money Laundering Program and Suspicious Activity Report Filing Requirements for Registered Investment Advisers, Department of the Treasury, Financial Crimes Enforcement Network (August 25, 2015), available here

SEC Amends Rule 2a-7 to Remove Credit Ratings References

Rule 2a-7 Amendments
The SEC recently adopted amendments to money market fund Rule 2a-7 that eliminate references to credit ratings. The amendments eliminate the requirements that money market funds: (i) invest only in securities that have received one of the two highest short-term credit ratings, or, if they are not rated, securities that are of comparable quality; and (ii) invest at least 97% of their assets in securities that have received the highest short-term credit rating.

Instead of focusing on credit ratings, money market funds will now be limited to investing in a security “only if the fund determines that the security presents minimal credit risks after analyzing certain prescribed factors.” Most notably, the change in language will affect the definition of “eligible security” under Rule 2a-7.

Moving forward, an eligible security will be one that “presents minimal credit risk to the fund.” In order to define minimal credit risk without reference to credit ratings, the SEC has codified earlier guidance related to the factors that may be used to determine that a security presents minimal credit risks. These factors include the issuer’s or guarantor’s:

  • financial condition;
  • sources of liquidity;
  • ability to react to future market-wide and issuer- or guarantor-specific events, including ability to repay debt in a highly adverse situation; and
  • strength of the issuer or guarantor’s industry within the economy and relative to economic trends and the issuer or guarantor’s competitive position within its industry.

The SEC added a fifth factor, suggesting that a minimal credit risks evaluation “may also include consideration of whether the price and/or yield of the security itself is similar to that of other securities in the fund’s portfolio.” The SEC adopting release also lists additional factors that may be considered for particular asset classes, such as municipal securities, conduit securities, other structured securities like variable rate demand notes, tender option bonds, extendible bonds, “step-up” securities or other structures, and repurchase agreements.

Practical Implications for Boards
Currently, when a security has been downgraded by a nationally recognized statistical rating organization, boards must promptly review whether the security still presents minimal credit risks. As the new amendments to Rule 2a-7 will remove the reference to credit ratings, money market funds must now adopt written procedures that require a fund’s adviser to provide ongoing reviews of the credit quality of each portfolio security to ensure that the security continues to present minimal credit risks. While the required frequency of review is not specified in the amendments, in its rule release, the SEC observes that “Many funds today engage in daily monitoring of changes… and do so even on an hourly basis if there are rapidly changing events. We believe that this type of monitoring is consistent with the ongoing monitoring requirement adopted today.”

While Rule 2a-7, in its current form, requires a written record of each eligibility determination, given the increased frequency of eligibility review under the amended rule, the related recordkeeping could quickly become unwieldy for many money market funds.In recognition of this, the amended rule requires a record of a determination only when the security is first acquired, and then at such times (or upon such events) as the board determines that the adviser must reassess whether a security presents minimal credit risks.

The compliance date for the Rule 2a-7 amendments is October 14, 2016.

Sources: Removal of Certain References to Credit Ratings and Amendment to the Issuer Diversification Requirement in the Money Market Fund Rule, Release No. IC-31828 (September 16, 2015), available here; SEC Removes References to Credit Ratings in Money Market Fund Rule and Form, SEC Press Release 2015-193 (September 16, 2015), available here

OCIE Provides Clearer Picture of Second Wave of Cybersecurity Examinations

As noted in our January and April Updates, earlier this year, the SEC announced a focus on cybersecurity compliance and controls as part of its 2015 Examination Priorities, and the Office of Compliance Inspections and Examinations (OCIE) published a risk alert with summary observations from its cybersecurity examinations of broker-dealers and investment advisers. OCIE recently issued another risk alert to provide information on the areas of focus for its second round of cybersecurity examinations, which is designed to build upon its previous examinations and further assess cybersecurity preparedness in the securities industry, including firms’ ability to protect customer information.

Generally, the upcoming examinations will involve gathering information on cybersecurity-related controls, as well as more testing to assess implementation of these controls. OCIE has indicated that it will focus on the following areas as it conducts its cybersecurity examinations:

  • Governance and Risk Assessment. Examiners may review:
    • Whether firms have cybersecurity governance and risk assessment processes relative to access rights and controls, data loss prevention, vendor management, training, and incident response;
    • Whether firms are periodically evaluating cybersecurity risks;
    • Whether firms’ controls and risk assessment processes are tailored to their business; and
    • The level of communication to, and involvement of, senior management and boards of directors.
  • Access Rights and Controls. Examiners may review:
    • Whether firms are using basic controls to prevent unauthorized access to systems or information (e.g., multifactor authentication and updating access rights after personnel or system changes);
    • How firms control access to various systems and data; and
    • Controls associated with remote access, customer logins, passwords, firm protocols to address customer login problems, network segmentation, and tiered access.
  • Data Loss Prevention. Examiners may review:
    • Controls in the areas of patch management and system configuration;
    • How firms monitor the volume of content transferred outside of the firm by employees or third parties;
    • How firms monitor for potentially unauthorized data transfers; and
    • How firms verify the authenticity of a customer request to transfer funds.
  • Vendor Management. Examiners may review:
    • Firm practices and controls related to vendor management, such as due diligence with regard to vendor selection, monitoring and oversight of vendors, and contract terms;
    • How vendor relationships are considered as part of the firm’s ongoing risk assessment process; and
    • How the firm determines the appropriate level of due diligence to conduct on a vendor.
  • Training. Examiners may review:
    • How employee and vendor training is tailored to specific job functions;
    • How training is designed to encourage responsible employee and vendor behavior; and
    • How procedures for responding to cyber incidents under an incident response plan are integrated into regular personnel and vendor training.
  • Incident Response. Examiners may review:
    • Whether firms have established policies, assigned roles, assessed system vulnerabilities, and developed plans to address possible future events; and
    • Whether firms have determined which firm data, assets, and services warrant the most protection to help prevent attacks from causing significant harm.

OCIE’s recent risk alert includes a sample document request list in an appendix that registrants can use to prepare for possible examination and to assess their cybersecurity effectiveness. The risk alert, along with the appendix, can be found at the link below.

Source: OCIE’s 2015 Cybersecurity Examination Initiative, National Exam Program Risk Alert, Vol. IV, Issue 8 (September 15, 2015), available here

Litigation and SEC Enforcement Actions

SEC Reaches Settlement with R.T. Jones Regarding Lack of Cybersecurity Policies and Procedures

R.T. Jones Capital Equities Management, Inc. (R.T. Jones), an SEC registered investment adviser, has reached a settlement agreement with the SEC in connection with charges that it failed to establish required cybersecurity policies and procedures, in violation of Rule 30(a) of Regulation S-P under the Securities Act (the “safeguards rule”). Without admitting or denying the charges, R.T. Jones has agreed to pay a $75,000 penalty.

R.T. Jones stored the personally identifiable information (PII) of roughly 100,000 individuals, including thousands of the firm’s clients, on a third-party hosted web server. In July 2013, the web server was hacked, compromising these individuals’ PII.

Upon discovering the attack, R.T. Jones promptly retained multiple cybersecurity consulting firms to confirm the attack and determine its scope. Shortly thereafter, R.T. Jones provided notice of the attack to every individual whose PII may have been compromised and offered free identity theft monitoring. As of the date of the SEC’s settlement action, there had been no claims of financial harm resulting from the attack.

Despite the immediate efforts of R.T. Jones to investigate and correct the consequences of the security breach, the SEC determined that R.T. Jones violated the safeguards rule designed to protect customer records and information from just such an attack. In particular, the SEC determined that R.T. Jones “failed to adopt any written policies and procedures to ensure the security and confidentiality of PII and protect it from anticipated threats or unauthorized access.”  By way of example, according to the SEC, R.T. Jones failed to conduct periodic risk assessments, implement a firewall, encrypt PII stored on its server, or maintain a response plan for cybersecurity incidents.

Marshall S. Sprung, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, observed, “As we see an increasing barrage of cyber attacks on financial firms, it is important to enforce the safeguards rule even in cases like this when there is no apparent financial harm to clients. Firms must adopt written policies to protect their clients’ private information and they need to anticipate potential cybersecurity events and have clear procedures in place rather than waiting to react once a breach occurs.”

For more information on the SEC’s expectations relating to cybersecurity and its 2015 cybersecurity examination initiative, see “OCIE Provides Clearer Picture of Second Wave of Cybersecurity Examinations,” above.

Sources: In the Matter of R.T. Jones Capital Equities Management, Inc., Investment Advisers Act Release No. 4202 (September 22, 2015), available here; SEC Charges Investment Adviser with Failing to Adopt Proper Cybersecurity Policies and Procedures Prior to Breach, SEC Press Release 2015-202 (September 22, 2015), available here

Dodd-Frank Extended to Internal Whistleblowing in the Second Circuit

The Second Circuit Court of Appeals, in Berman v. Neo@Oglivy, recently created a circuit split regarding the question of whether an employee who suffers retaliation because he or she reports securities violations internally, but not to the SEC, can obtain the anti-retaliatory protections provided under the Dodd-Frank Act (Dodd-Frank). While the Fifth Circuit Court of Appeals, in Asadi v. G.E. Energy, found that the anti-retaliatory protections in Dodd-Frank require reporting directly to the SEC, the Second Circuit disagreed, holding that the statute is ambiguous enough to warrant deference to the SEC’s rulemaking, which protects internal reporters.

In the recent Berman case, the plaintiff, Daniel Berman, was the finance director of Neo@Oglivy LLC (Neo), a digital media agency. He was responsible for financial reporting and generally accepted accounting principles (GAAP) compliance, as well as internal accounting procedures. In April 2013, Mr. Berman was terminated, allegedly because a senior officer at Neo became angry with him for reporting to his supervisors what he believed to be violations of GAAP, the Sarbanes-Oxley Act (SOX), and Dodd-Frank. In August 2013, Mr. Berman reported these same allegations to the audit committee of Neo’s parent company, WPP Group USA, Inc. (WPP). He did not provide any of this information to the SEC until October 2013, after the limitations period on one of his SOX claims had ended. Mr. Berman sued both Neo and WPP, claiming he was terminated in violation of the whistleblower protection provisions in Section 21F of Dodd-Frank.

The crux of the legal question—and the source of the circuit split—lies in the somewhat murky and potentially conflicting whistleblower provisions of Dodd-Frank and Dodd-Frank’s cross-reference to SOX. The Second Circuit defined the problem as follows:

This appeal concerns the relationship between the definition of “whistleblower” in Section 21F and one subdivision of the provision prohibiting retaliation, which was added by a conference committee just before final passage. Subsection 21F(a)…contains Subsection 21F(a)(6), which defines “whistleblower” to mean “any individual who provides . . . information relating to a violation of the securities laws to the Commission. . . .” …Subsection 21F(h), the retaliation protection provision, contains subsection 21F(h)(1)(A), which provides:

(A) In General

No employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower—

(i) in providing information to the Commission in accordance with this section;

(ii) in initiating, testifying in, or assisting in any investigation or judicial or administrative action of the Commission based upon or related to such information; or

(iii) in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7201 et seq.), this chapter [i.e., the Exchange Act], including section 78j-1(m) of this title [i.e., Section 10A(m) of the Exchange Act], section 1513(e) of Title 18, and any other law, rule, or regulation subject to the jurisdiction of the Commission…

This appeal concerns the arguable tension between the definitional subsection, subsection 21F(a)(6), which defines “whistleblower” to mean an individual who reports violations to the Commission, and subdivision (iii) of subsection 21F(h)(1)(A), which, unlike subdivisions (i) and (ii), does not within its own terms limit its protection to those who report wrongdoing to the SEC. On the contrary, subdivision (iii) expands the protections of Dodd-Frank to include the whistleblower protection provisions of Sarbanes-Oxley, and those provisions, which contemplate an employee reporting violations internally, do not require reporting violations to the Commission.

While the Fifth Circuit ruled the definition of “whistleblower” in subsection 21F(a)(6) as controlling, the Second Circuit held that, due to the tension within Dodd-Frank and between Dodd-Frank and SOX, the statutory provisions were ambiguous, warranting consideration of the SEC’s rulemaking (known as Chevron deference, discussed below). Thus, the Second Circuit looked to the SEC’s release accompanying Exchange Rule 21F-2, which explained that “the statutory anti-retaliation protections [of Dodd-Frank] apply to three different categories of whistleblowers, and the third category [described in subdivision (iii) of subsection 21F(h)(1)(A)] includes individuals who report to persons or governmental authorities other than the Commission.” Given the clear message in the SEC’s release, the Second Circuit held that Mr. Berman, and all internal reporters, are entitled to the same whistleblower protections as those who report violations directly to the SEC.

Sources: Berman v. Neo@Ogilvy LLC, No. 14-4626 (2nd Cir. Sept. 10, 2015), available here; Asadi v. G.E. Energy (USA), L.L.C., 720 F.3d 620 (5th Cir. 2013), available here; Securities Whistleblower Incentives and Protections, Release No. 34-64545, 76 Fed. Reg. 34300-01 (June 13, 2011); Second Circuit Extends Dodd-Frank to Internal Whistleblowing, Federal Securities Law Reporter, Report Letter 2695 (Sept. 23, 2015).

180-Day Limit for “Wells” Notice Proves Unreliable in Montford Associates Case

Section 4E of the Securities Exchange Act, added with the passage of Dodd-Frank, provides that “not later than 180 days after the date on which Commission staff provides a written Wells notification to any person, the Commission staff shall either file an action against such person or provide notice to the Director of the Division of Enforcement of its intent to not file an action.”

In March 2011, Montford and Company, Inc. (d/b/a Montford Associates), a registered investment adviser founded by Ernest Montford, received a Wells notice informing Mr. Montford that the SEC intended to recommend proceedings against both him and Montford Associates for failing to disclose receipt of payments for promoting investments managed by a third-party investment manager who later was found liable for misappropriating investor funds. On September 7, 2011, 187 days after sending the Wells notice, the SEC instituted administrative proceedings against Mr. Montford and Montford Associates.

Mr. Montford and Montford Associates filed a motion to dismiss the proceeding as time-barred under Section 4E(a)(1), and in response, the SEC submitted a declaration that the SEC director had extended the deadline under Section 4E(a)(2), which allows the director to extend the deadline for certain complex actions. The presiding Administrative Law Judge (ALJ) denied the motion to dismiss and found that Mr. Montford and Montford Associates violated the Advisers Act and “violated a basic premise of an investment adviser’s role” as a fiduciary, acted with a high degree of scienter, and failed to acknowledge any wrongdoing. The ALJ barred Mr. Montford from associating with any investment adviser, and ordered civil penalties and disgorgement. Mr. Montford and Montford Associates appealed to the full Commission, arguing the enforcement proceeding must be dismissed because it was time-barred under Section 4E(a). The SEC found no merit in their claim that Section 4E operates as a statute of limitations and instead found that Section 4E is “intended to operate as an internal-timing directive, designed to compel our staff to complete investigations, examinations and inspections in a timely manner, and not as a statute of limitations.” Accordingly, the Commission rejected their claim that Section 4E required dismissal of the proceeding and affirmed the ALJ’s findings and sanctions.  
 
Mr. Montford and Montford Associates petitioned the D.C. Circuit for a review of the Commission’s order, and the Court affirmed the sanctions. The Court found that Section 4E was entitled to “Chevron deference,” alluding to Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc. (June 25, 1984), in which the court found that when a law is ambiguous, the court shall defer to a permissible interpretation of the executive branch or government agencies. The Court concluded that the SEC’s interpretation of the rule as an internal guideline was reasonable, especially in light of the absence in Section 4E of a consequence where the SEC brings an action after the 180-day deadline.

Sources: “Court Rules There’s No 180-Day Limit on SEC Investigations,” Think Advisor (July 30, 2015), available here; Thomas O. Gorman, “Deadlines & SEC Enforcement: When 180 Days Is Not 180 Days,” Wall Street Lawyer, Vol. 19 Issue 8 (August 2015); Montford and Company, Inc., doing business as Montford Associates and Ernest V. Montford, Sr. v. Securities and Exchange Commission, (U.S. Court of Appeals for the D.C. Circuit July 10, 2015), available here; In the Matter of Montford and Company, Inc., d/b/a Montford Associates, and Ernest V. Montford, Sr., Investment Advisers Act Release No. 3829 (May 2, 2014), available here; Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 104 S.Ct. 2778 (1984), available here

The information contained herein is based on a summary of legal principles. It is not to be construed as legal advice. Individuals should consult with legal counsel before taking any action based on these principles to ensure their applicability in a given situation.

Media Contact 

If you have a media request or need an attorney with particular knowledge for comment, please contact Susan Steberl, Director of Marketing, at 414.287.9556 or ssteberl@gklaw.com.

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