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Regulation and Compliance > Federal Regulation > SEC

Dishonest Services: SEC’s Fight Against Public Corruption

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We often think of laws directed toward combating public corruption as anti-bribery and anti-kickback laws. Such laws generally require proof of quid pro quo, that there is an actual or implicit agreement for a public official to provide favors through his or her public office to a private party in exchange for personal benefits from that party.

In 2010, a landmark United States Supreme Court decision involving former Enron CEO Jeffrey Skilling solidified the requirement of a quid pro quo when the federal government attempts to use an “honest services fraud” theory under the federal mail and wire statutes. Honest services fraud began as an outgrowth of two distinct federal statutes that criminalize the use of the mails or wires to execute fraud schemes.

For over half a century, federal prosecutors successfully used these statutes to prosecute “intangible harms” in public corruption cases. Post-Skilling, this landscape has narrowed. Generally speaking, while bribery and kickbacks still constitute honest services fraud, self-dealing and conflicts of interest may not. Indeed, the recent trial of former Virginia Gov. Robert McDonnell focused on whether such a quid pro quo agreement existed. The requirement creates a high legal threshold for the government in prosecuting alleged public corruption.

Based on this understanding, some investment advisors, fund managers, broker-dealers and other financial firms that do business with public entities deploy compliance systems and risk assessment protocols that are geared to detect and prevent gifts, entertainment and benefits to personnel of public pensions and municipalities that may be construed as quid pro quo to obtain investment businesses from such public entities. However, in light of a growing trend of the Securities and Exchange Commission bringing enforcement cases involving public corruption, considerations should be given as to whether such compliance and risk assessment protocols should be re-calibrated beyond a focus on potential quid pro quo.

In particular, the SEC has increasingly brought enforcement actions using the anti-fraud provisions of the federal securities law to fight against what it views to be “pay-to-play” public corruption schemes in the securities markets. In doing so, the SEC is only required to prove intentional, reckless or negligent misstatement or non-disclosure of material benefits, or conflicts of interest in connection with the offer and sale of securities. Thus, the SEC typically focuses on what was said or not said by an investment advisor, fund manager or broker-dealer to the governing body of a public entity, such as a public pension board of trustees, regarding any material benefits that may have been provided to any personnel of the public entity.

Similarly, the SEC would look into what was said or not said to the public entity by the public official who received the benefits. Under this disclosure approach, the SEC does not need to prove the existence of quid pro quo under the federal securities laws. The SEC’s increasing use of this approach has important compliance and risk implications for firms that solicit investment businesses from public entities.

A Seed Is Planted

Over a decade ago, a federal court decision in Chicago cemented the SEC’s ability to use the federal securities law to attack alleged public corruption when the offer and sale of securities was involved. In 2002, the SEC brought a civil enforcement action against Miriam Santos, the former treasurer of the city of Chicago, and two broker-dealer registered representatives who obtained city investment business per approval by Santos. The allegations by the SEC should sound familiar to those attuned to political public corruption matters. The SEC alleged that the registered representatives secretly made thousands of dollars in cash payments to Santos and, as a result of those cash payments, received thousands of dollars in compensation from city business.

The reps filed a motion to dismiss the case by challenging the SEC’s ability to pursue a de facto public corruption case under the federal securities laws. U.S. District Judge James Zagel denied the defendants’ motion. (Incidentally, Zagel is the same federal judge who years later would preside over the corruption trial of former Illinois Gov. Rod Blagojevich.) In his opinion, Zagel stated that the alleged scheme, if proven, would constitute violations of the anti-fraud provisions of the federal securities laws because material facts regarding payments to the treasurer were withheld from the city, the victim of the fraud. Importantly, Zagel found that even though there were no allegations that the underlying securities transactions were in any way improper or fraudulent, it was sufficient that there were misstatements and omissions of material facts regarding the payments by the registered representatives. According to Zagel, such statements and omissions were in connection and “coincided” with the sale of securities. This ruling from Zagel, a noted jurist, set the foundation for future SEC cases against public corruption.

SEC Ramps Up Anti-Corruption Effort

After the Santos decision, the SEC brought additional enforcement actions involving alleged public corruption. For instance, in 2009 and later in 2010, the SEC brought enforcement actions against the former deputy comptroller of New York, a top political advisor and a principal of a private equity firm in connection with alleged sham finders’ fees for investment by a New York pension fund. In 2012, the SEC brought an enforcement action against the former CEO of a California public pension plan for allegedly falsifying letters regarding $20 million in fees to a friend’s placement agent firms.

Around the same time, the SEC Enforcement Division set up the Municipal Securities and Public Pensions Unit, a national special enforcement team that, among other duties, investigates cases involving pay-to-play and public corruption involving the municipalities and public pensions. In May 2012, that SEC unit brought a high-profile enforcement action against former Detroit Mayor Kwame Kilpatrick, former Detroit Treasurer Jeffrey Beasley and an investment advisor firm and principal that obtained business from two Detroit public pensions. The allegations in the SEC complaint described over $125,000 of entertainment and travel provided by the investment advisor to the former mayor, the former treasurer and their family and friends, including flights on private jets, concert tickets, hotel rooms and limousines.

The SEC complaint also described subsequent investment of over $100 million by the pension funds with the defendant investment advisor. Although these allegations suggest a quid pro quo arrangement, the complaint made clear that the SEC was relying on the securities-fraud theory of failure to disclose material facts that does not require proof of quid pro quo. For instance, the complaint specifically stated that the “failure by [defendants] to disclose these gifts and the resulting conflicts of interest constituted a fraud on the pension funds.” The complaint further stated that the then mayor and treasurer, as pension board trustees, along with the defendant investment advisor firm and principal, were fiduciaries to the pension funds. They thus had a duty to disclose the gifts and the “conflicts of interest created by the gifts.”

In addition, there is an emerging trend in which the SEC appears to be attacking potential public corruption based on allegations that municipalities or quasi-public entities (and their officials) failed to disclose material payments or potential conflicts of interests in such entities’ offering statements when such entities offer and sell municipal bonds to the investing public. For instance, in June 2014, the SEC filed a civil complaint against UNO Charter School Network for alleged failure to disclose in its bond offering document conflicted transactions, including allegations that school construction grant money it received from the state of Illinois went to a subcontractor owned by the brother of UNO’s then chief operating officer. That same month, the SEC filed a civil complaint against the city of Harvey, Illinois, and its former comptroller alleging, among other things, the city’s failure to disclose in its bond offering documents past diversion of bond proceeds, including undisclosed payments to the then city comptroller.

Practical Implications of SEC Approach

Greater risk of SEC scrutiny. By relying on the anti-fraud provisions of the federal securities laws, the SEC faces a lower legal threshold to bring enforcement cases involving alleged public corruption, as long as the alleged misconduct is in connection with the offer and sale of securities or related to investment advisory services. In addition, the SEC, as a civil agency, can bring such cases based merely on allegations of negligent, as opposed to intentional, conduct.

As confirmed by recent enforcement cases in this area, we should expect even greater examination and enforcement focus by the SEC to detect and investigate alleged public corruption involving the securities markets. For example, if your firm does business with public entities and is subject to SEC examination, expect SEC examiners to review documents reflecting expense reimbursement requests for meals and entertainment of public officials and employees. In addition to the anti-fraud provisions, the SEC will continue to focus on compliance with rules affecting campaign contributions by investment advisors and broker-dealers that do business with certain public entities.

Greater risk of criminal exposure. The U.S. Department of Justice can bring criminal prosecutions based on alleged violations of the federal securities laws. However, unlike the SEC, the criminal authorities must prove criminal intent and cannot rely on negligence or even reckless conduct. Nevertheless, it would not be surprising that the availability of the anti-fraud provisions of the federal securities laws, without any quid pro quo requirements, would encourage the criminal authorities to take greater interest in investigating and prosecuting alleged public corruption involving the securities markets. Recent statements by senior SEC officials suggest there will be greater coordination between the SEC and the Department of Justice in this area.

Compliance, Risk Assessment Focus on Undisclosed Benefits

In light of the SEC’s scrutiny on undisclosed material benefits, it is not enough for compliance and risk assessment protocols to have documentation or certification attesting that gifts, entertainment or other benefits to public officials and employees of a public entity client or investor are not in exchange for investment business. Instead, consider having a compliance and risk assessment protocol that can at least answer the following critical questions:

1. Would any proposed entertainment, gifts or benefits to a public official or employee be material to the public entity in its decision to retain or invest with your firm?

In answering this question, consider defining benefits broadly. Charitable contributions are particularly tricky, even though such contributions are typically for good causes and are not benefits to public officials. For instance, charitable contributions that involve supporting golf tournaments and banquets attended by public officials could be viewed as benefits to the public officials. Also beware of contributions to charities in which a public official or his family members have significant control or involvement.

In determining what benefits may be material under the federal securities laws, remember that what may be considered immaterial in a corporate or business setting may be material when factoring in the typically lower salaries of public officials.

Further, some internal ethics policies of public entities specifically quantify the monetary value of benefits that are either prohibited or required to be approved. Such policies, often available on the public entities’ websites, would be useful in identifying benefits that may be material.

2. If potentially material entertainment, gifts or benefits will be or have been provided to a public official or employee, are such benefits accurately disclosed to the public entity client or investor?

Since the SEC’s legal theory focuses on undisclosed material benefits, when in doubt, potentially material benefits to a public official or employee should be disclosed to a public entity client or investor prior to that public entity making a decision to retain or invest with your firm. Disclosure should be to the governing board or at least to the general counsel or attorney of the public entity. Some public entities already require their vendors to complete forms disclosing gifts and benefits to their officials and personnel. Make sure such disclosures are complete and accurate.

Finally, a simple “gut check” rule: If you or your firm finds it potentially awkward or embarrassing if certain entertainment, gifts or benefits are known to the public, those benefits may very well be the types of material benefits that need to be avoided or disclosed.


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