Securities Law Archives - Page 21 of 26

National Future Association (NFA) Issues Guidance on Annual Affirmation Requirement for CPO and CTA Exemptions

Kenneth M. Rosenzweig and James M. Brady of Katten Muchin Rosenman LLP recently had an article, National Future Association (NFA) Issues Guidance on Annual Affirmation Requirement for CPO and CTA Exemptions, featured in The National Law Review:

Commencing in 2012, each person or entity claiming an exemption from commodity pool operator (CPO) or commodity trading advisor (CTA) registration must annually affirm the applicable exemption within 60 days of the end of each calendar year. Any person or entity that does not affirm its applicable CPO or CTA exemption will be deemed to have requested to withdraw the exemption. The affirmation process can be completed through the National Future Association’s online exemption system.

More information is available here.

Private Equity Fund Is Not a “Trade or Business” Under ERISA

An article, Private Equity Fund Is Not a “Trade or Business” Under ERISA, written by Stanley F. Lechner of Morgan, Lewis & Bockius LLP was recently featured in The National Law Review:

District court decision refutes 2007 Pension Benefit Guaranty Corporation opinion letter and could provide potential clarity to private equity firms and private equity funds in determining how to structure their investments.

In a significant ruling that directly refutes a controversial 2007 opinion by the Pension Benefit Guaranty Corporation (PBGC) Appeals Board, the U.S. District Court for the District of Massachusetts held in Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund that a private equity fund is not a “trade or business” under the Employee Retirement Income Security Act (ERISA) and therefore is not jointly and severally liable for millions of dollars in pension withdrawal liability incurred by a portfolio company in which the private equity fund had a substantial investment.^[1] This ruling, if followed by other courts, will provide considerable clarity and relief to private equity funds that carefully structure their portfolios.

The Sun Capital Case

In Sun Capital, two private equity funds (Sun Fund III and Sun Fund IV) invested in a manufacturing company in 2006 through an affiliated subsidiary and obtained a 30% and 70% ownership interest, respectively, in the company. Two years after their investment, the company withdrew from a multiemployer pension plan in which it had participated and filed for protection under chapter 11 of the Bankruptcy Code. The pension fund assessed the company with withdrawal liability under section 4203 of ERISA in the amount of $4.5 million. In addition, the pension fund asserted that the two private equity funds were a joint venture or partnership under common control with the bankrupt company and thus were jointly and severally liable for the company’s withdrawal liability.

In response to the pension fund’s assessment, the private equity funds filed a lawsuit in federal district court in Massachusetts, seeking a declaratory judgment that, among other things, they were not an “employer” under section 4001(b)(1) of ERISA that could be liable for the bankrupt company’s pension withdrawal liability because they were neither (1) a “trade or business” nor (2) under “common control” with the bankrupt company.

Summary Judgment for the Private Equity Funds

After receiving cross-motions for summary judgment, the district court granted the private equity funds’ motion for summary judgment. In a lengthy and detailed written opinion, the court made three significant rulings.

First, the court held that the private equity funds were passive investors and not “trades or businesses” under common control with the bankrupt company and thus were not jointly and severally liable for the company’s withdrawal liability. In so holding, the court rejected a 2007 opinion letter of the PBGC Appeals Board, which had held that a private equity fund that owned a 96% interest in a company was a trade or business and was jointly and severally liable for unfunded employee benefit liabilities when the company’s single-employer pension plan terminated.

A fundamental difference between the legal reasoning of the court in the Sun Capital case compared to the reasoning of the PBGC in the 2007 opinion is the extent to which the actions of the private equity funds’ general partners were attributed to the private equity fund. In the PBGC opinion, the Appeals Board concluded that the private equity fund was not a “passive investor” because its agent, the fund’s general partner, was actively involved in the business activity of the company in which it invested and exercised control over the management of the company. In contrast, the court in Sun Capital stated that the PBGC Appeals Board “misunderstood the law of agency” and “incorrectly attributed the activity of the general partner to the investment fund.”^[2]

Second, in responding to what the court described as a “creative” but unpersuasive argument by the pension fund, the court concluded that the private equity funds did not incur partnership liability due to the fact that they were both members in the affiliated Delaware limited liability company (LLC) that the funds created to serve as the fund’s investment vehicle in purchasing the manufacturing company. Applying Delaware state law, the court stated that the private equity funds, as members of an LLC, were not personally liable for the liabilities of the LLC. Therefore, the court concluded that, even if the LLC bore any responsibility for the bankrupt company’s withdrawal liability, the private equity funds were not jointly and severally liable for such liability.

Third, the court held that, even though each of the private equity funds limited its investment in the manufacturing company to less than 80% (i.e., 30% for Fund III and 70% for Fund IV) in part to “minimize their exposure to potential future withdrawal liability,” this did not subject the private equity funds to withdrawal liability under the “evade or avoid” provisions of section 4212(c) of ERISA.^[3] Under section 4212(c) of ERISA, withdrawal liability could be incurred by an entity that engages in a transaction if “a principal purpose of [the] transaction is to evade or avoid liability” from a multiemployer pension plan. In so ruling, the court stated that the private equity funds had legitimate business reasons for limiting their investments to under 80% each and that it was not clear to the court that Congress intended the “evade or avoid” provisions of ERISA to apply to outside investors such as private equity funds.

Legal Context for the Court’s Ruling

Due to the distressed condition of many single-employer and multiemployer pension plans, the PBGC and many multiemployer pension plans are pursuing claims against solvent entities to satisfy unfunded benefit liabilities. For example, if a company files for bankruptcy and terminates its defined benefit pension plan, the PBGC generally will take over the plan and may file claims against the company’s corporate parents, affiliates, or investment funds that had a controlling interest in the company, or the PBGC will pursue claims against alleged alter egos, successor employers, or others for the unfunded benefit liabilities of the plan that the bankrupt company cannot satisfy.

Similarly, if a company contributes to a multiemployer pension plan and, for whatever reason, withdraws from the plan, the withdrawing company will be assessed “withdrawal liability” if the plan has unfunded vested benefits. In general, withdrawal liability consists of the employer’s pro rata share of any unfunded vested benefit liability of the multiemployer pension plan. If the withdrawing company is financially unable to pay the assessed withdrawal liability, the multiemployer plan may file claims against solvent entities pursuant to various legal theories, such as controlled group liability or successor liability, or may challenge transactions that have a principal purpose of “evading or avoiding” withdrawal liability.

Under ERISA, liability for unfunded or underfunded employee benefit plans is not limited to the employer that sponsors a single-employer plan and is not limited to the employer that contributes to a multiemployer pension plan. Instead, ERISA liability extends to all members of the employer’s “controlled group.” Members of an employer’s controlled group generally include those “trades or businesses” that are under “common control” with the employer. In parent-subsidiary controlled groups, for example, the parent company must own at least 80% of the subsidiary to be part of the controlled group. Under ERISA, being part of an employer’s controlled group is significant because all members of the controlled group are jointly and severally liable for the employee benefit liabilities that the company owes to an ERISA-covered plan.

Private Investment Funds as “Trades or Businesses”

Historically, private investment funds were not considered to be part of an employer’s controlled group because they were not considered to be a “trade or business.” Past rulings generally have supported the conclusion that a passive investment, such as through a private equity fund, is not a trade or business and therefore cannot be considered part of a controlled group.^[4]

In 2007, however, the Appeals Board of the PBGC issued a contrary opinion, concluding a private equity fund that invested in a company that eventually failed was a “trade or business” and therefore was jointly and severally liable for the unfunded employee benefit liabilities of the company’s defined benefit pension plan, which was terminated by the PBGC. Although the 2007 PBGC opinion letter was disputed by many practitioners, it was endorsed by at least one court.^[5]

The Palladium Capital Case

In Palladium Capital, a related group of companies participated in two multiemployer pension plans. The companies became insolvent, filed for bankruptcy, withdrew from the multiemployer pension plans, and were assessed more than $13 million in withdrawal liability. Unable to collect the withdrawal liability from the defunct companies, the pension plans initiated litigation against three private equity limited partnerships and a private equity firm that acted as an advisor to the limited partnerships. The three limited partnerships collectively owned more than 80% of the unrestricted shares of the defunct companies, although no single limited partnership owned more than 57%.

Based on the specific facts of the case, and relying in part on the PBGC’s 2007 opinion, the U.S. District Court for the Eastern District of Michigan denied the parties’ cross-motions for summary judgment. Among other things, the court stated that there were material facts in dispute over whether the three limited partnerships acted as a joint venture or partnership regarding their portfolio investments, whether the limited partnerships were passive investors or “investment plus” investors that actively and regularly exerted power and control over the financial and managerial activities of the portfolio companies, and whether the limited partnerships and their financial advisor were alter egos of the companies and jointly liable for the assessed withdrawal liability. Because there were genuine issues of material fact regarding each of these issues, the court denied each party’s motion for summary judgment.

Significance of the Sun Capital Decision

In concluding that a private equity fund is not a “trade or business,” the Sun Capital decision directly refutes the 2007 PBGC opinion letter and its reasoning. If the Sun Capital decision is followed by other courts, it will provide welcome clarity to private equity firms and private equity funds in determining how to structure their investments. Among other things, both private equity funds and defined benefit pension plans would benefit from knowing whether or under what circumstances a fund’s passive investment in a portfolio company can constitute a “trade or business” thus subjecting the private equity fund to potential controlled group liability. Similarly, both private equity firms and private equity funds need to know whether a court will attribute to the private equity fund the actions of a general partner or financial or management advisors in determining whether the investment fund is sufficiently and actively involved in the operations and management of a portfolio company to be considered a “trade or business.”

The Sun Capital decision was rendered, as noted above, against a backdrop in which the PBGC and underfunded pension plans are becoming more aggressive in pursuing new theories of liability against various solvent entities to collect substantial sums that are owed to the employee benefit plans by insolvent and bankrupt companies. Until the law becomes more developed and clear regarding the various theories of liability that are now being asserted against private equity funds investing in portfolio companies that are exposed to substantial employee benefits liability, it would be prudent for private equity firms and investment funds to do the following:

Structure carefully their operations and investment vehicles.
Be cautious in determining whether any particular fund should acquire a controlling interest in a portfolio company that faces substantial unfunded pension liability.
Ensure that the private equity fund is a passive investor and does not exercise “investment plus” power and influence over the operations and management of its portfolio companies.
Conduct thorough due diligence into the potential employee benefits liability of a portfolio company, including “hidden” liabilities, such as withdrawal liability, that generally do not appear on corporate balance sheets and financial statements.
Be aware of the risks in structuring a transaction in which an important objective is to elude withdrawal liability.

Similarly, until the law becomes more developed and clear, multiemployer pension plans may wish to devote particular attention to the nature and structure of both strategic and financial owners of the businesses that contribute to their plans and should weigh and balance the risks to which they are exposed by different ownership approaches.

_{[1]. Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, No. 10-10921-DPW, 2012 WL 5197117 (D. Mass. Oct. 18, 2012), available here.}

_{[2]. Sun Capital, slip op. at 17.}

_{[3]. Id. at 29-30.}

_{[4]. See e.g., Whipple v. Comm’r., 373 U.S. 193, 202 (1963).}

_{[5]. See, e.g., Bd. of Trs., Sheet Metal Workers’ Nat’l Pension Fund v. Palladium Equity Partners, LLC (Palladium Capital), 722 F. Supp. 2d 854 (E.D. Mich. 2010).}

Industry Groups File Suit to Block Conflict Minerals Rules and Resource Extraction Rules

The National Law Review recently featured an article by the Public Companies Group of Schiff Hardin LLP titled, Industry Groups File Suit to Block Conflict Minerals Rules and Resource Extraction Rules:

Late last month, the U.S. Chamber of Commerce and the National Association of Manufacturers filed suit in federal court requesting that the court either modify or set aside the SEC rules governing so-called conflict minerals. The petition, filed before the U.S. Court of Appeals for the District of Columbia Circuit, does not state a specific basis for the legal challenge, but in a joint statement, the groups stated that though well-intentioned, the rules are “not an effective approach to this complex issue” and characterized the rule as imposing “an unworkable, overly broad and burdensome system that will undermine jobs and growth and may not achieve Congress’s overall objectives.” This petition comes on the heels of the suit filed against the SEC early last month by a collection of industry groups asking a federal district court to block implementation of the resource extraction disclosure rules promulgated in late August. The plaintiff trade groups raised a number of claims, including a faulty cost-benefit analysis and deficiencies under the Administrative Procedures Act and Exchange Act. It is not clear at this time if the SEC will stay either of the controversial rules on a voluntary basis after negotiation with plaintiffs’ counsel. Should the SEC refuse to do so, the plaintiffs could petition the court for injunctive relief.

CFTC Issues Interpretive Letter Regarding Cleared Swaps Customer Collateral

The National Law Review recently published an article by Kevin M. Foley and James M. Brady of Katten Muchin Rosenman LLP, CFTC Issues Interpretive Letter Regarding Cleared Swaps Customer Collateral:

Katten Muchin Rosenman LLP

The Division of Clearing and Risk (DCR) of the Commodity Futures Trading Commission issued an interpretive letter regarding cleared swaps customer collateral requirements under Part 22 of the CFTC’s rules. The DCR interpretation addresses a number of issues with respect to which derivatives clearing organizations (DCOs) and clearing member futures commission merchants (FCMs) requested clarification, including: (1) limitations on the use of cleared swaps customer collateral; (2) the use of variation margin, in particular if a DCO elects to net variation margin across an FCM’s cleared swaps customers; (3) comingling of cleared swaps customer collateral; (4) the processes by which an FCM may report to a DCO its customers’ portfolio of rights and obligations; (5) the circumstances in which a DCO may accept cleared swaps customer collateral in excess of the DCO’s initial margin requirements; and (vi) the determination of the value of cleared swaps customer collateral in the event of an FCM default.

The DCR interpretive letter is available here.

Congress Continues to Examine Data Brokers’ Practices

The National Law Review recently published an article, Congress Continues to Examine Data Brokers’ Practices, written by Michelle Cohen of Ifrah Law:

The chairmen of the Congressional Bipartisan Privacy Caucus just released the responses they received from nine major data brokers whom they queried in July about how each broker collects, assembles and sells consumer information to third parties. In their responses, the nine companies — Acxiom, Epsilon, Equifax, Experian, Harte-Hanks, Intelius, Fair Isaac, Merkle and Meredith Corp. – generally asserted that they were not data brokers. Some companies claimed they analyze data rather than broker it. Copies of the brokers’ responses and the original letters can be found here.

Interestingly, several of the brokers acknowledged obtaining their data from social networks such as LinkedIn and Facebook, in addition to telephone directories, government agencies, and financial institutions.

The legislators issued a joint statement in which they noted shortcomings in the brokers’ answers, stating that “many questions about how these data brokers operate have been left unanswered, particularly how they analyze personal information to categorize and rate consumers.”

Members of Congress have indicated that they will continue to scrutinize the data brokerage industry. Issues of particular concern for the legislators include: the sale of personal information to third parties for targeted advertising, the gathering and selling of information relating to children and teenagers, and the lack of transparency in data brokers’ practices and available information. The Privacy Caucus has expressed concern that many Americans do not know how the industry operates and that controls may be lacking for individuals over their own information.

The FTC has already called on Congress to address data brokers’ practices through legislation. In March, the FTC advocated for legislation to “address the invisibility of, and consumers’ lack of control over, data brokers’ collection and use of consumer information.” We anticipate continued review of data brokers by Congress and federal agencies including the FTC. Companies in the data compilation business should continue to monitor ongoing proceedings.

It should be noted, however, that not all companies that gather personal information actually “broker” it in a manner that raises concern. Some companies compile information and remove identifying data before providing it to third parties; other companies gather information under contract for a business with whom a consumer has an existing business relationship – as a means to promote better customer service by tailoring offerings that will be of interest to consumers generally or to a particular consumer. Many consumers have indicated a willingness to receive these types of tailored offerings.

Recent Case Suggests How Private Equity Funds Can Protect Against Unfunded Pension Liabilities of Portfolio Companies

The National Law Review recently published an article, Recent Case Suggests How Private Equity Funds Can Protect Against Unfunded Pension Liabilities of Portfolio Companies, written by Joseph S. Adams, Laurence R. Bronska, Nancy S. Gerrie, Andrew C. Liazos, and Maureen O’Brien of McDermott Will & Emery:

McDermott Will & Emery

A significant objective for a private equity (PE) fund when making an investment is to avoid exposing itself to portfolio company liabilities. Generally, corporate law would protect the purchaser of a controlling interest in an acquired corporation against portfolio company liabilities as long as the acquired company is operated independently of the purchaser. However, special considerations apply under theEmployee Retirement Income Security Act (ERISA), the federal law that governs employee benefit plans. ERISA makes all members of a controlled group liable on a joint and several basis for any pension-related liabilities of single employer and multi-employer pension plans. The Pension Benefit Guaranty Corporation (PBGC), the federal agency responsible for overseeing these pension plans, has been aggressive in broadly interpreting what is a “controlled group” for this purpose and in pursuing PE funds for pension liabilities incurred by portfolio companies. But a recent case out of the U.S. District Court for the District of Massachusetts signals that courts may not agree with the PBGC’s broad assessment of pension liability for PE funds.

In a recently decided case, Sun Capital Partners III L.P. v. New England Teamsters and Trucking Industry Pension Fund, D. Mass., No. 1:10-cv-10921-DPW, 10/18/12, the U.S. District Court for the District of Massachusetts became the first court to reject a multi-employer pension plan’s attempt to rely on PBGC precedent to assess a PE fund with a portfolio company’s unfunded pension liabilities. While this likely is not the last word on this subject, the Sun Capital Partners case offers a roadmap for how a PE fund may take a position to avoid controlled group liability for single employer and multi-employer pension liability.

Background

Title IV of ERISA imposes joint and several liability with respect to a broad array of pension liabilities, including an employer’s minimum funding contributions to a single employer pension plan, unfunded pension liabilities upon plan termination, PBGC premium payments and withdrawal liability under a multi-employer pension plan. Under ERISA, joint and several liability applies to any entity under common control with the employer sponsoring the pension plan.

The definition of “common control” is interpreted under federal tax rules that are applicable to tax-qualified plans under Section 414 of the Internal Revenue Code (the Code).
These Internal Revenue Service (IRS) regulations have long provided that entities are under common control if they are “trades or businesses” that share common ownership of 80 percent or more (by vote or value).
In the 1987 case of Commissioner v. Groetzinger, the Supreme Court of the United States established a test for when an activity constitutes a “trade or business” for these purposes. Under Groetzinger, for a person to be engaged in a trade or business, the primary purpose of the activity must be income or profit, and the activity must be performed with continuity and regularity.

In 2007, the PBGC issued an opinion (PBGC Appeals Board opinion dated September 26, 2007) finding that a PE fund was engaged in a trade or business. According to the PBGC, the PE fund subject to the opinion was engaged in a “trade or business” because it had a stated purpose of creating a profit; provided investment services; and had a general partner that received management fees, a carried interest and consulting fees (i.e., the PE funds did not receive just investment income as a passive investor similar to an individual investor). The PBGC stated that this activity was regular and continuous because of the size of the PE fund and its profits.

The Sun Capital Decision

In the Sun Capital Partners case, the court determined that the one-time investment of capital by a PE fund into a portfolio company was a passive investment and did not result in the PE funds engaging in a trade or business. The investment was structured such that the portfolio company was owned by two PE funds in a 70/30 split. Each PE fund had a general partner, and each general partner had a management company that performed consulting and advisory services. The PE funds, as shareholders, could appoint members of the board of directors of the portfolio company.

In its decision, the court determined that receipt of non-investment compensation in the form of consulting, management or advisory fees and carried interest by the management companies and the general partners could not be attributable to the PE funds. The non-investment income was a result of a contractual relationship between the management companies, the general partners and the portfolio company. The court found that the receipt of this non-investment income did not mean that the PE funds themselves were engaged in the full range of the general partners’ activities. The PE funds themselves did not perform any consulting, advising or management services, and did not have employees, own any office space, or make or sell any goods. In fact, on tax returns, the PE funds reported only capital gains and dividends, both sources of investment income. Further, the court held that the ability of the PE funds to appoint the board of directors of the portfolio company did not mean that the funds were engaged in a trade or business, because such appointments were made in the PE funds’ capacity as shareholders of the portfolio company. The court also noted that the fact that the same persons signed the management agreements representing both sides of the contract was not persuasive evidence of engaging in a trade or business, since officers of different entities can sign in different capacities.

The court in the Sun Capital Partners case expressly considered and declined to rely on the 2007 PBGC opinion. Importantly, the court held that the 2007 PBGC opinion had misapplied the theory of agency and incorrectly imputed the management companies’ or general partners’ actions to the PE funds. In addition, the court held that, as a matter of law, the PBGC had misapplied the Groetzinger test and other relevant tax law precedent.

Finally, the court determined that the structuring of the PE funds’ investment in the portfolio company (using multiple funds each owning less than 80 percent of the portfolio company) did not violate ERISA provisions allowing certain transactions to be undone if they were undertaken to evade or avoid ERISA liabilities. Although the PE funds admitted that one of the reasons that the investment was structured to be two funds with a 70/30 split was in order to minimize pension liability risk, the court found that ERISA’s evade-or-avoid provisions did not apply in this context, because such provisions were meant to apply to sellers rather than first-time investors. Indeed, as the court noted, if the investment was undone and the controlled group determined without regard to the investment as contemplated under ERISA, the PE funds would still not be liable. Thus, application of the evade-or-avoid provisions did not make sense in this context.

Implications

Most importantly, this decision provides support for the widely held position that a PE fund is not engaged in trade or business and cannot be determined to be under common control with its portfolio companies under Code Section 414. Under this interpretation, no PE fund could be held liable for withdrawal liability under a multi-employer pension plan, or unfunded benefits liabilities upon termination of a single employer plan (or minimum funding or contractually required ongoing contributions to such plans), because PE funds are not engaged in a trade or business. Further, if the PE fund cannot be held liable, then the chain of ownership between portfolio companies held by the same private equity fund is also broken. This decision also provides significant leverage to negotiate with the PBGC or a multi-employer pension fund should a PE fund be defending itself against the PBGC or multi-employer pension fund for pension liability claims.

In order to avail themselves of the benefits of this decision, PE funds should evaluate their operations and contractual relationships to determine if such operations and relationships are comparable to those outlined by the court in the Sun Capital Partners case. In addition, PE funds may wish, when possible, to structure future investments across multiple funds with each fund owning less than 80 percent of the portfolio company in order to minimize risk of pension liability.

On November 2, 2012, the multi-employer pension fund appealed the decision in the Sun Capital Partners case to the U.S. Court of Appeals for the First Circuit.

Securities Fraud National Institute – November 15-16, 2012

The National Law Review is pleased to bring you information about the upcoming Securities Fraud Conference by the ABA:

This national institute is an educational and professional forum to discuss the legal and ethical issues surrounding securities fraud.

Program highlights include:

Panel discussions with senior officials from the U.S. Securities and Exchange Commission and U.S. Department of Justice
Updates since the passage of the Dodd-Frank Act
Breakout sessions focused on new financial reform legislation
Strategies for practitioners when representing clients under investigation, indicted and during appeals

When

November 15 – 16, 2012

Where

Westin New Orleans Canal Place
100 Rue Iberville
New Orleans, LA, 70130-1106
United States of America

Securities Fraud National Institute – November 15-16, 2012

The National Law Review is pleased to bring you information about the upcoming Securities Fraud Conference by the ABA:

This national institute is an educational and professional forum to discuss the legal and ethical issues surrounding securities fraud.

Program highlights include:

Panel discussions with senior officials from the U.S. Securities and Exchange Commission and U.S. Department of Justice
Updates since the passage of the Dodd-Frank Act
Breakout sessions focused on new financial reform legislation
Strategies for practitioners when representing clients under investigation, indicted and during appeals

When

November 15 – 16, 2012

Where

Westin New Orleans Canal Place
100 Rue Iberville
New Orleans, LA, 70130-1106
United States of America

Securities Fraud National Institute – November 15-16, 2012

The National Law Review is pleased to bring you information about the upcoming Securities Fraud Conference by the ABA:

This national institute is an educational and professional forum to discuss the legal and ethical issues surrounding securities fraud.

Program highlights include:

Panel discussions with senior officials from the U.S. Securities and Exchange Commission and U.S. Department of Justice
Updates since the passage of the Dodd-Frank Act
Breakout sessions focused on new financial reform legislation
Strategies for practitioners when representing clients under investigation, indicted and during appeals

When

November 15 – 16, 2012

Where

Westin New Orleans Canal Place
100 Rue Iberville
New Orleans, LA, 70130-1106
United States of America

Court Rules SEC Cannot Invoke Its Investigatory Powers to Circumvent Discovery Rules

The National Law Review recently published an article regarding the SEC’s Investigatory Powers written by Jennifer Tomsen of Greenberg Traurig, LLP:

A Texas federal district court recently refused to reconsider its order imposing sanctions on the U.S. Securities and Exchange Commission (“SEC”) for conducting an “extra-judicial deposition” of a third party without providing notice to defendants in a pending civil action to which the third party’s testimony was relevant. Order on reconsideration, SEC v. Life Partners Holdings, Inc. et al., Case No. 1:12-CV-00033-JRN, in the United States District Court for the Western District of Texas, Austin Division (Sept. 27, 2012)[Doc. 56]; original order dated Aug. 17, 2012 [Doc. 47]. The court determined that the SEC obtained the testimony for use in the pending case and could not invoke its investigatory powers to do an end-run around the governing discovery rules.

The orders were entered in a case brought by the SEC against financial services firm Life Partners Holdings, Inc. and three of its executives, Brian Pardo, R. Scott Penden, and David M. Martin. The SEC alleged that defendants systematically underestimated life expectancy estimates the company used to price life settlement transactions so as to create a false appearance of a steady stream of earnings.

After the SEC complaint was filed but before the parties’ Rule 26(f) conference, the SEC deposed a non-party witness, the auditor for Life Partners. The SEC did not seek the court’s permission to depose a witness prior to the conference and did not give notice to defendants. Defendants sought to preclude the SEC from using any documents or testimony obtained by the witness for any purpose relating to the litigation. The SEC argued that the deposition was a valid exercise of its regulatory authority to investigate potential violations of federal securities laws and was not an attempt to obtain ex parte discovery.

Although the filing of a civil action “does not inhibit the SEC’s broad authority to investigate securities-law violations,” administrative agencies are bound by the Federal Rules of Civil Procedure (“FRCP”) when they are parties in a civil action. The rules require leave of court to take a deposition before the Rule 26(f) conference, and notice to all parties must be provided. The question for the court was whether the deposition was taken as part of a regulatory investigation unrelated to the civil action.

The SEC claimed it was investigating the auditor to ensure he had fulfilled his professional obligations, but District Judge James R. Nowlin found the deposition was not taken solely to investigate matters outside the complaint. The auditor was examined regarding Life Partners’ revenue recognition and other practices, “as well as Defendants Pardo, Peden, and Martin’s knowledge of the same — all of which form the very bases of Plaintiff’s Complaint in this case.” The court also rejected the SEC’s assertion that testimony relating to the civil suit “inadvertently came out.” The SEC relied on SEC v. O’Brien, 467 U.S. 735 (1984) for the proposition that the target of an SEC investigation is not entitled to notice of investigative subpoenas issued to third parties. The court held that O’Brien did not apply because the subpoena was issued after the Complaint was filed “and with the intention of obtaining evidence against the named Defendants.”

The court also rejected the claim that there was no prejudice because the SEC provided the deposition transcript to defendants, who were free to depose the auditor themselves. The court determined that the lack of notice deprived defendants of their ability to cross-examine the auditor and object to the testimony elicited.

The court asserted, “Plaintiff cannot administer an extra-judicial deposition regarding an investigation, elicit testimony during that deposition regarding allegations made in the Complaint for use against defendants, and then claim immunity from the FRCP by labeling the deposition as ‘investigative.’” The multiple violations of the FRCP warranted sanctions because the deposition without notice to opposing counsel “frustrated the fair examination” of the witness. In addition to awarding Defendants $5,000 in attorney’s fees, the court prohibited the SEC from using the deposition testimony in the civil case.

In a motion for reconsideration, the SEC claimed that the court had “introduced a new rule of law” that “upon the filing of a civil suit, the Commission may not use its investigatory powers to investigate any related violations.” The court rejected this interpretation of its order. It noted that the SEC Enforcement Manual itself cautioned staff about issuing investigative subpoenas after commencement of a civil action because “[a] court might conclude that the use of investigative subpoenas to conduct discovery is a misuse of the SEC’s investigative powers and circumvents the court’s authority and limits on discovery in the Federal Rules of Civil Procedure.”

While the deposition in this case appears to have been a fairly transparent effort to circumvent the FRCP to gain discovery for use in the civil case, the court’s order reinforces important limits on the SEC’s investigatory powers. The court sent a clear signal that it would not tolerate abuses of those powers to gain an advantage over civil litigants. Defendants in an SEC proceeding should be alert for the possibility of such abuses. They will find strong support in this order should the SEC take non-party depositions without notice that could be relevant to the civil suit.

Category: Securities Law

National Future Association (NFA) Issues Guidance on Annual Affirmation Requirement for CPO and CTA Exemptions

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