Summary of Selected Programs from SIA Compliance & Legal Division’s 2006 Annual Seminar

Last week, the Securities Industry Association Compliance & Legal Division hosted its annual seminar, with some 1500 securities industry participants and observers attending. Although the seminar is a great opportunity to catch up with old friends, and perhaps meet new ones, it is first and foremost the single best educational seminar of its kind. Participants in the securities industry represent a substantial part of the client base we serve at Sutherland Asbill & Brennan, whether it be a broker-dealer, investment bank, hedge fund, mutual fund or some other business or individual associated with the financial services industry. Sutherland Asbill & Brennan is a proud sponsor of the seminar and, as you might expect, many of our attorneys look forward to attending each year. This year no fewer than 12 of our securities litigation and arbitration, enforcement, and regulatory attorneys attended.

Understanding that not all of our clients and friends can attend the seminar, and even those who do cannot take part in every program and workshop, each year we make it a point to send a summary of certain selected seminars and workshops to our clients and others. This year is no exception, and we hope you will find the summary that follows informative. As always, if you have any questions about our summary, or if we can otherwise be of service to you, please contact any of the partners below.

1. Comments from the Regulators
2. What’s New in Arbitration
3. Annuities and Other Insurance Products
4. Ethical Considerations of an In-House Lawyer
5. Internal Investigations
6. Customer Complaints
7. Compliance Officers Roundtable
8. Handling a Regulatory Investigation
9. Challenges Of Electronic Discovery
10. Civil Litigation Update
11. Major Liabilities

High-ranking representatives from the SEC, NASD, and NYSE were on hand to brief seminar participants on current issues and initiatives. Although speaking separately and at various times throughout the seminar, they touched on several common themes. While expressing a strong commitment to protecting investors, they also acknowledged the rising cost of compliance and the industry’s growing impatience with duplicative compliance efforts. Other common themes reflected in their remarks included the need for greater cooperation from regulated firms, concerns about the accuracy of information provided to regulators and the public, the misuse of customers’ proprietary information, and the importance of adequate internal controls. The SEC, NASD, and NYSE are all scrutinizing hedge funds and variable annuities, among other investment products. Additional highlights of their remarks are provided below.

Speaking at Monday’s general session, Ms. Schapiro acknowledged the industry’s perception that it is over-regulated. She described various steps being taken to address concerns about the perceived inefficiency of NASD’s regulatory efforts, including an overall reduction in the number of NASD sweep requests, coordination of sweep requests with other regulators, and a reduction in the pace and volume of regulation.

Ms. Schapiro, who will become CEO of NASD later this year, has launched a "listening tour" intended to give her a better understanding of the industry’s views and concerns. She will be meeting throughout the year with the leaders of securities firms, large and small, all across the country. Although still in its early stages, the tour has already made Ms. Schapiro keenly aware of the industry’s perception that regulation is "more of a problem than a solution." She hopes also to use the tour as an opportunity to share her views on the importance of self-regulation in the overall regulatory scheme.

Ms. Schapiro reported on various NASD initiatives, such as the joint NASD-NYSE report to the SEC regarding analyst conflicts of interest. Among other things, this report recommended creating a limited exemption from the registration requirements for research reports produced by individuals whose primary job is something other than research, for example, registered representative newsletters or trader commentary. Other recommendations were to (1) permit web-based disclosure of conflicts of interest instead of publication in the research report itself, (2) amend the definition of "research report" to exclude mutual fund and direct participation program sales material, which are encompassed within other rules, and (3) eliminate quiet periods before and after the expiration, termination or waiver of a lock-up agreement.

Other initiatives that Ms. Schapiro felt would put NASD "ahead of the curve" include:

• Addressing potential problems stemming from the fact that 45% of employees who leave a job take a cash distribution from their 401(k) plan, rather than rolling the funds over into another qualified plan.
• Providing balanced guidelines regarding variable annuities.
• Harmonizing the requirements of other products that compete with the sale of securities (such as "plain vanilla" annuities).
• Using its experience from September 11 and Hurricane Katrina to prepare for a potential bird flu pandemic.

Speaking at Tuesday’s general session, Mr. Ketchum focused on recent compliance-related accomplishments achieved in the industry. Like Ms. Schapiro, Mr. Ketchum cited improved coordination between the NYSE and NASD. For example, the NYSE and NASD recently created uniform rules for branch offices, CEO certification, and business entertainment.

Despite these and other initiatives, Mr. Ketchum acknowledged that there remained room for improvement. For example, the self-regulatory organizations must continue their efforts to develop a single consistent set of rules and eliminate the duplication of compliance efforts. Although the cost of compliance has increased significantly in recent years, Mr. Ketchum felt that most of the increased expenditures were necessary. He admonished those in attendance not to let concern for the bottom line lessen their commitment to compliance, noting that diminished compliance poses a serious threat to the industry as a whole.

Mr. Ketchum described efforts to improve the transparency of NYSE’s examination process. He referred to recently circulated memos that provide guidance on examinations and explain the factors that may lead to the imposition of sanctions. These memos, as well as proposed rules and other useful information, can be found on the NYSE website at www.nyse.com .

NYSE compliance priorities for 2006 will include:

• Non-managed fee-based accounts.
• Internal control rules.
• Retail investor supervision.

• Activity letters that do not appear to have adequate central office oversight.

Five representatives from the SEC participated in a panel discussion Tuesday morning. Like the speakers from the NYSE and NASD, these panel members described measures being taken by the SEC to make the regulatory process more efficient. For example, to avoid inundating firms with successive sweep requests, the SEC checks with the self-regulatory organizations before issuing a sweep. If the NYSE or NASD is already addressing the issue, the SEC will let that organization handle the exam.

Panel members reviewed the factors that might lead to a referral of a matter to the SEC enforcement division. Regulators consider whether internal violations occurred, whether fraud appears to be involved, and whether investors were harmed. Matters referred to the enforcement division in 2005 involved "bread and butter" issues such as the unsuitable sale of variable annuities, periodic payment plans, unauthorized trading, market timing and late trading, misuse of non-public information, e-mail retention, and the misappropriation of funds by registered representatives.

SEC compliance priorities for the coming year will include:

• Sales practices violations, especially those involving new investment products, variable annuities, mutual funds (e.g., sales charges, loads, and break-point discounts), and firms that target vulnerable investors (e.g., members of the military, senior citizens).

• Supervision issues, especially a firm’s failure to follow its written supervisory procedures.
• Trading issues, such as compliance with rules for the handling of orders, implementation of controls to catch clearly erroneous trades, and the adequacy of controls to prevent misuse of customer trading information.
• Fixed-income issues, such as excessive mark-ups, pricing, best execution, and timely reporting.
• Internal controls.
• Net capital and customer reserves.
• Anti-money laundering efforts.

• Information security.
• Business continuity.

Three separate sessions were devoted to current issues in securities arbitrations. Appearing on separate panels were Linda Fienberg, President of NASD Dispute Resolution; George Friedman, Executive Vice President & Director of Arbitration for NASD; and Karen Kupersmith, Director of Arbitration for the NYSE. Topics discussed during the arbitration sessions included concern over the expansion of discovery in arbitration, the differences between the NASD and NYSE arbitrator selection processes, and the role of industry and public arbitrators in the arbitration system. In addition, Ms. Fienberg and Mr. Friedman described some of the major initiatives under way at NASD. These are summarized below.

NASD will tweak the "explained award" amendment but move forward with it, despite concerns expressed during the comment period. The proposed amendment would allow customers and, in industry controversies, associated persons, to submit a request for an explained decision no later than the pre-hearing exchange. An explained decision is defined as "a fact-based award stating the reason(s) each alleged cause of action was granted or denied." Legal authorities and damage calculations would not have to be included in an explained decision.

Some of the changes being made to the explained award provision as a result of the 200-plus comments submitted include:

• Instead of paying the panel $600, as originally proposed, $300 will be paid to the arbitrator who drafts the award, and the other two arbitrators will be paid $150 each.
• The explained decision would be required to state expressly that the award is intended to provide the parties to the particular case with information, and does not set a precedent for any other case.
• The proposal will be modified to clarify that each claim does not have to be addressed in the explained award. Examples will be made available.

The final rule can be expected sometime in the spring or early summer.

Ms. Fienberg announced that NASD will soon issue a revised version of Rule 10322 regarding third-party subpoenas. The new version will clarify that only arbitrators may issue subpoenas. In addition, before a subpoena is issued, the party seeking the subpoena must provide the other parties with notice and a copy of the subpoena. The other parties must object to the issuance of the subpoena within ten days of receiving notice. Ms. Fienberg further explained that the party obtaining documents pursuant to the subpoena would have to allow the other parties an opportunity to review and copy the documents at their own expense.

Ms. Fienberg reported on NASD’s pilot program that will allow parties to agree to have their discovery disputes resolved by an arbitrator who is specially trained in discovery issues. This program is about to get under way, primarily in NASD’s Southeast and West Regions. A pool of discovery arbitrators has been pre-selected by attorneys representing both claimants and respondents. Discovery arbitrators will have the power to impose sanctions.

Additionally, Ms. Fienberg reported that NASD’s discovery guidelines are under review. Revisions may be ready by the end of the year. These revisions will be based on input from its Discovery Task Force, as well as input from representatives from the public and those who are frequent users of the forum. NASD is still working to reach a consensus about what documents should be included in document production lists.

NASD is in the process of formalizing Rule 10334, having completed a successful pilot program. This rule will allow attorneys to communicate directly with the arbitrators on behalf of their clients without going through NASD staff.

In 2004, NASD launched a program allowing elderly or infirm claimants to request that their cases be expedited. Since June 2004, nearly 300 cases have been expedited and only five requests have been denied. Expedited cases take an average of about 12.4 months to reach completion, as compared to 16.9 months for non-expedited cases.

Rule 2130 went into effect almost two years ago. NASD began tracking expungement requests in November 2005; since then, there have been 150 requests for expungement and 16 denials under Rule 2130.

Ms. Fienberg noted that expungement may be granted only upon request, and the request may come in the form of a stipulated award. The NASD is asking arbitrators to examine the settlement agreements themselves. Ms. Fienberg cautioned that, if a panel grants expungement in a case in which the broker-dealer made a substantial settlement payment to claimants, NASD will look very carefully at the case and may not waive its right to be named as a party in the court confirmation proceeding.

NASD has proposed various amendments to Rule 10308, which deals with the selection of arbitrators by the parties. For example, as a part of the general reorganization of the Customer Code, which is addressed in more detail in the following section, NASD is proposing to provide parties with three lists of proposed arbitrators, instead of the two they currently receive. As in the current system, parties would receive a list of public arbitrators and a list of industry arbitrators. Under the amended rule, parties would receive an additional list of arbitrators qualified to serve as chairperson. Another change in the amended rule would allow parties a limited number of strikes per list, instead of the unlimited strikes allowed under the current system.

In another initiative, NASD has submitted a proposal to modify Rule 10308 to narrow the definition of a public arbitrator. The proposed change would exclude persons with significant ties to the securities industry, who, under the current rule, still qualify as public arbitrators. The proposed definition would exclude an individual who works for or who is an officer or director of "an entity that directly or indirectly controls, is controlled by, or is under common control with, any partnership, corporation, or other organization that is engaged in the securities business." The proposed definition also would exclude an individual whose spouse or immediate family member works for or is an officer or director of such an entity.

The final proposed rewrite of the Customer and Industry Codes will be available within the next couple of weeks. The Customer Code will include a provision for dispositive motions, but will be amended to state that such motions should be granted only in "extraordinary circumstances." This language will not be explained, but examples will be provided. The examples will be limited to clear-cut situations, such as claims outside the statute of repose and claims barred by an accord and satisfaction or settlement and release.

The Annuity and Insurance Products panel addressed several topics and hot issues relating to the sale of these products. The key topics covered by this panel were proposed NASD Rule 2821 and Equity Indexed Annuities.

Proposed NASD Rule 2821, which relates to transactions in deferred variable annuities, includes suitability and supervision requirements tailored specifically to these products. These requirements include: (1) guidelines for recommendations of the product by the registered representative; (2) principal review; (3) supervision of sales; and (4) training of registered representatives regarding the sale of deferred variable annuities. Thomas Selman of NASD sat on the panel and stressed that the key suitability determinations a representative will need to make before recommending this product are as follows:

• The customer has a long term investment objective.
• The customer has a need for the features of the product.
• The annuity as a whole is suitable, including the sub-accounts.

Mr. Selman further stated that the above determinations will need to be documented and signed by the registered representative. While Mr. Selman acknowledged that NASD Rule 2821 is still a "proposed" rule, he stated that NASD is "rounding third and on the way to home base" with Rule 2821. Mr. Selman noted that NASD received over 1400 comments on this proposed rule, mostly negative. A possible modification that might be made to the proposed rule before it is finalized relates to the timing of principal supervisory review and approval, which now is required "prior to transmitting the customer application to the insurance company." Mr. Selman stated that NASD is "thinking strongly about modifying this provision" and to require earlier approval.

The panel also identified Equity Indexed Annuities ("EIAs") as a hot topic, and, according to another panel, EIAs are the number one topic for NASD exams in 2006. The panel did not address the key issue of whether an EIA is or is not a security, but rather discussed the supervisory requirements under the Outside Business Activity rule. Mr. Selman noted that firms must adopt procedures under the Outside Business Activity rule that require representatives to "promptly" notify the firm when selling an unregistered EIA. Mr. Selman stressed that "promptly" does not mean that this is something a representative can do annually; it should be done upon each sale. Mr. Selman also pointed out that the suitability rule can be implicated if a representative is recommending an exchange out of a variable annuity into an EIA because the sale would involve a security. Finally, the panel stated that some firms are planning to run the EIA business through the broker-dealer, and, in those instances, the firm must review any EIA transaction as it would any other security transaction. In other words, even if NASD may not regulate the product, it regulates the individuals and members who sell the product.

Finally, the panel alerted the audience to red flags that may arise with sales of annuities and insurance products. The panel stressed that the following are red flags:

• Young customers – the customer should not be too young, although NASD declined to say how young was too young.

• Need for immediate or near term liquidity – NASD views annuities as long term investments.

• Customers who have not made the maximum contribution to their qualified retirement plans.

• Customers who have no need for the features of a particular annuity or insurance product.

This session included a spirited discussion of various hypothetical situations and many questions from the audience. One area that drew a fair amount of attention related to the possibility that in-house lawyers could find themselves engaging in the unlicensed practice of law, even if they were just doing their job. Although it is common knowledge that lawyers may not litigate in court (or in arbitration proceedings in some cases, as we have seen in Florida and elsewhere) in a state in which they are not licensed, the rules governing the rendering of legal advice across state lines by in-house lawyers is less well-known. Recognizing that this is a potential issue, the American Bar Association crafted Model Rule 5.5 which states, in pertinent part, as follows:

Although Model Rule 5.5 may offer relief to in-house lawyers who provide legal services "to the lawyer's employer or its organizational affiliates and are not services for which the forum requires pro hac vice admission," the analysis does not stop there. Indeed, while some states have adopted the model rule,¹ others seem to have rejected it outright.² Other jurisdictions have adopted their own rules or recognize parts of Model Rule 5.5.³ Still other states have defined in-house counsel as not being engaged in the practice of law or have issued an ethical opinion authorizing in-house practitioners.⁴ The message, of course, is that in-house lawyers must check the ethical rules of all of the states in which they might be deemed to be engaged in the practice of law. This check should occur before, not after, the legal advice or service is rendered.

Another "hot topic" addressed in this session involved the SEC’s ability to demand a waiver of the attorney-client privilege and require the production of an in-house attorney’s notes and memoranda during the course of an investigation. Prior to the Sarbanes-Oxley Act and the Seaboard 21(a) Report, investigations conducted by the SEC staff were more adversarial in nature. Now, the regulators expect the firm’s full cooperation, which in some cases includes a waiver of the attorney-client privilege. The firm must consider that possibility early in the investigation and must plan accordingly. Specifically, the in-house lawyer should consider not memorializing legal conclusions in written work product and should explain to management early in the investigation the repercussions of the waiver. The panel pointed out that the possibility of a waiver might inhibit the initial fact gathering in the early stages of the investigation.

The Internal Investigations session discussed a critically important facet of the securities industry - - self-policing. It did so by exploring a fact pattern that raised increasingly more challenging issues as more and more facts were uncovered. Some of the issues that were discussed and points that were made are summarized below.

Panel members noted the importance of identifying and gathering the key documents quickly and effectively when conducting an internal investigation. It may be advisable to include the legal team in the document gathering process, they noted, so that the attorney-client privilege may be invoked when appropriate. Legal counsel also may help ensure that the right documents are gathered and that they remain secured. Panelists cautioned against relying too heavily on those who may be directly involved in the substance of the investigation because of the potential self-interest and the possible ramifications associated with the documents.

Interviewing the key witnesses, especially the broker, will need to be done early in the investigation, panel members noted. They observed that it is best for the interviews to be conducted without other potential witnesses present, particularly those who may have a self-interest in the outcome of the investigation. In other words, non-lawyers who ask to be present probably ought not to be allowed to be there.

Attendees were urged to keep in mind that, at some point in the investigation, the investigation itself may be the subject of a second investigation, during which the questions that were asked (and not asked) and the judgments that were made may be questioned. As a result, careful thought needs to be given to who takes notes and what notes are taken. Non-lawyers should not be permitted to make notes of the interviews, the panelists stated, and even lawyers need to be careful because of the possibility that the attorney-client privilege may be waived at some point during the investigation.

Some witnesses may be reluctant to cooperate in an investigation even though they may have a duty to do so. Deciding how to deal with this problem, like most, may be fact specific. Others may refuse to speak to the firm’s attorney unless the attorney agrees to keep the information obtained confidential. Several reasons why the firm’s counsel should be reluctant to make such an agreement were pointed out. Still other witnesses may refuse to speak without their own counsel present, and panel members agreed that such a request ordinarily could be honored. Still others may ask that the firm retain counsel for them before they will answer questions during the investigation. Normally, firms are not under an obligation to pay for counsel for an employee, panelists noted, although there may be circumstances when that may be done.

Panel members expressed some concern about having the compliance department handle internal investigations without legal counsel because, if the conduct of the compliance department itself becomes an issue, the work product they created will not be protected from disclosure by any privilege. In-house counsel should be involved in internal investigations right from the start, and will likely serve as the primary contact for any outside counsel who are brought in. As with most aspects of an investigation, when (if ever) to bring in outside counsel is likely to be fact specific. The benefits of bringing in outside counsel, and doing so early, start with the fact that outside counsel will likely have the expertise and the resources to conduct a thorough investigation. The concern about resources is not insignificant, panelists observed. Internal investigations can be time consuming and distracting for employees. Also, using outside counsel should add independence to an internal investigation, and this may be beneficial if the investigation is viewed after-the-fact by a regulator, the panel noted.

If the firm decides not to hire an outside law firm, the firm’s legal staff, or the compliance department at the direction of the legal staff, must promptly interview the employee and his or her supervisors and gather and secure the documents relating to the improper activities. The in-house lawyer should keep in mind that during the course of the investigation the firm may decide to waive the privilege and thus some or all of the notes and memoranda prepared by the lawyer may have to be turned over to the regulators.

The panel noted that the in-house lawyer also must consider recommending a disciplinary action against the employee to ensure that the questionable activity does not continue. The lawyer is under an obligation to follow up to ensure that the firm’s management is (1) taking appropriate action against the employee, and (2) considering revisions to the firm’s procedures that will enable future misconduct to be detected.

The session on customer complaints covered new trends in the area, including the products and allegations that are currently sparking the most customer complaints and a new reporting process that is being examined by the SROs.

Panel members observed that complaints related to variable annuities and the disclosure of nonpublic personal information appear to be on the rise. These latter complaints are based on Regulation S-P, which restricts a financial institution's ability to disclose nonpublic personal information about consumers and imposes certain notice requirements when disclosure has occurred. Regulation S-P was promulgated by the SEC under the Gramm-Leach-Bliley Act.

It appears that complaints involving variable annuities are most likely to attract a regulator’s attention when they involve a customer over the age of 70 and a big surrender charge. Panel members indicated that regulators may want to look beyond the black and white of what a customer signed and may speak directly with the customers to confirm their understanding of the variable annuity.

The process that each firm may use in responding to customer complaints may vary from firm to firm. One principal difference is that some firms use compliance personnel to respond, others use legal counsel, and others use operations or even branch managers to handle the response. The panel noted that regulators want to see well reasoned and substantive responses to complaints, and some might prefer to have the response come from an attorney to demonstrate that the firm took the matter seriously. Neither regulators nor most arbitration panels appreciate response letters that read "Dear Customer, Your Complaint is Denied." The author of any response to a customer complaint may safely assume that the response will be analyzed by a regulator or may appear as an exhibit at an arbitration proceeding, or both.

The NYSE expects to implement a rule change later this year that will require additional customer complaint information to be filed with quarterly 351(d) reports. NASD-only firms already have to report much of this information. The NYSE rule change will provide greater consistency in the reporting requirements of the two organizations. NASD also expects to make certain changes to Rule 3070(c). The pending changes are a result of a joint initiative between the NYSE and NASD.

Once the new reporting requirements are in place, firms will be required to: (1) identify the person to be contacted by the SRO in the event of a customer complaint; (2) assign a unique number to each reported complaint; (3) identify the period during which the conduct at issue took place; (4) disclose the amount in dispute; and, for NASD members, (5) report oral complaints.

The panel noted that an intermediate appellate court in New York recently held fast to its decision in a 1991 case that statements made by a broker-dealer on a Form U-5 are absolutely privileged and will not give rise to a defamation claim. See Cicconi v. McGinn, Smith & Co., Inc., 808 N.Y.S. 2d 604 (N.Y. App. Div. 2005). The U-5 at issue stated that the employee’s termination was "performance based." Not every state affords absolute immunity for U-5 filings, as New York does. In several states, a firm enjoys only a qualified immunity, which may be overcome by a showing that the firm acted with actual malice when it made the filing. Although the decision did not address Form U-4 filings, the court’s rationale would seem to apply to those filings as well, the panel stated.

During this session, a panel of chief compliance officers discussed their roles at their various firms. They all agreed that measuring the effectiveness of compliance measures is their chief concern. Panel members also agreed that the worst thing for a firm is to have a written policy that is not followed. The next worst thing is to have an oral policy because it is hard to prove that it even exists. Panel members agreed, too, that their advisory role is becoming undervalued. They all agreed that their advisory role should not become a "gotcha!" role.

There was consensus that the stature of the compliance department is more important than its structure. Compliance personnel should be involved when the firm’s business leaders are making decisions and planning new products or expansion. Moreover, compliance should be interwoven into the entire structure of the firm. Departments such as legal, human resources, operations and technology, credit, audit, etc. should all be involved. However, the panel did note that there should also be clarity of roles and responsibilities between departments. Additionally, when talking to other departments, these CCOs do not typically use the word "compliance." Instead they talk about "reputational risks," which they believe those outside compliance tend to heed more closely.

Using a hypothetical scenario, the moderator and panel members leading this session took those in attendance through a mock regulatory investigation. Lest there be any doubt about the importance of a regulatory investigation, listeners were reminded more than once that the stakes were very high. The firm could face corporate sanctions (including the shuttering of the firm) as well as bad publicity.

The panel emphasized four goals to keep in mind during the course of the investigation. These are to: (1) complete the investigation as quickly as possible, with minimal disruption to the business of the client; (2) minimize the likelihood of a criminal referral, a particularly crucial goal when dealing with allegations of fraud; (3) take immediate steps to preserve relevant documents, including electronic records; and (4) avoid adverse or surprise publicity. The panel emphasized the need to act proactively to achieve these goals.

The panel identified several steps that should be taken at the outset of a regulatory investigation. The firm should position itself to cooperate with the regulators. Counsel (both inside and, if applicable, outside counsel) should be involved from the beginning. Additionally, evidence must be protected. Relevant documents should be identified and preserved, and all evidence should be reviewed. Employees with relevant knowledge should be interviewed as quickly as possible. Certain employees may need their own counsel.

Rumors about the investigation must be controlled. All employees who know about the investigation should be cautioned to treat the investigation as confidential and to exercise caution when sharing information with other employees.

Key issues should be identified quickly so that they may be used as a framework for responding to the investigation. Those responding to the investigation should have a thorough understanding of the relevant securities laws. They also should strive to gain an understanding of the investigator’s perception of the facts.

The panel emphasized the importance of establishing credibility with the regulators. They expressed the view that cooperation may minimize the possibility of discipline. On the other hand, if the SEC believes that the recipient of an informal request is failing to comply in a prompt and thorough manner, it will seek a formal order of investigation, usually without any warning, in order to issue subpoenas. Therefore, communication with the regulators should be regular and prompt, but factual representations should not be made to them until enough investigation has been done to ensure that what is represented is accurate.

The panel mentioned the Seaboard 21(a) report, in which the SEC outlines the specific factors that it deems relevant when evaluating a firm's effort to cooperate with an investigation. These factors are self-policing, self-reporting, remediation, cooperation, and appropriate internal discipline. Walter G. Ricciardi, the SEC panelist, observed that, if firms are cooperative, honest, and quick to conduct their own investigation, and if the SEC feels that it is being kept apprised of the self-investigation and believes that the investigation is being carried out in an ethical manner, the SEC will take a more hands-off approach. Additionally, if the firm compensates victims, the SEC might not bring any sanctions or charges against the firm.

In this session and another dealing with essentially the same topic, there was an interesting discussion about the extent to which cooperation with the regulators would lead to a reduced sanction if an enforcement action is brought. In connection with this discussion, two panelists mentioned (and made very positive remarks about) an article co-authored by Sutherland Asbill & Brennan Partner, Brian Rubin. The article, "Cooperation, Only More So: What it Takes To Receive Credit for Cooperating With NASD ," Securities Regulation & Law Report, October 24, 2005, specifically addresses this issue. There was general agreement among panel members that, while cooperation is a good thing, it is extremely difficult to quantify just how much that cooperation is worth. The reported cases very rarely mention cooperation expressly and, even when they do, they do not state just how much money or time off was saved as a result of the cooperation. In addition, as one panelist noted, it is not possible to compare the actual sanctions imposed with the sanctions that the staff had initially sought (i.e., the sanctions that were, presumably, discounted), since this information is not generally available.

Despite the emphasis on cooperation with regulators, the panel noted that attorneys should still advocate zealously on behalf of their clients. Bear in mind that every communication with the regulators is an opportunity to present your client's version of the facts, explain the key elements of your client’s defense, and elicit information from the regulators about the focus of their investigation. Regulators expect firms to argue the legal and regulatory significance of their facts, but Mr. Ricciardi cautioned that asserting a legally frivolous defense may cost you your credibility.

The failure to retain and produce electronic data when required to do so has become an independent source of potential liability regardless of any underlying wrongdoing, panel members cautioned during the session on electronic discovery. A survey of 15 cases in which sanctions were sought based on electronic document retention issues revealed that sanctions were awarded in 13. In part, this is because a mere negligence standard is being applied, without any requirement that bad faith or willful destruction of data be shown. "The tail is now wagging the dog," the panel warned.

The obligation to retain relevant records, including e-mails and other electronic records, is triggered any time an industry-wide investigation is announced, even though the firm is not specifically mentioned. When an investigation is announced and litigation reasonably can be anticipated, a broad litigation hold should be put in place. In addition to traditional electronic data such as e-mails, other forms of electronic data, such as audio recordings (voice-mail), which need not be retained in the ordinary course of business, should be retained once an investigation has begun. The panel’s consensus was that firms should not use systems that allow voice-mail to be sent via e-mail because that can trigger a duty to retain and cause multiple problems. The hold also should include interviewing any relevant players, asking them broadly about all of the information sources they use, and getting a snapshot of all of their data.

Metadata (data that exist beneath the surface of an electronic document and reflect, for example, formatting or prior versions of the document) should be produced as responsive to document requests, unless it is clear that it is not being requested. When a document is sent via e-mail attachment in a format such as Microsoft Word (.doc), metadata are embedded in the document. If production without metadata has been deemed appropriate, and the firm wishes to make its production via an electronic format, documents produced in a .pdf (Adobe Acrobat) format will not contain any metadata.

There is a consensus forming that, if requested, electronic documents must be produced in their "native format" (for example, as a Microsoft Word document or a Microsoft Outlook (.pst) file), and not in .pdf format. This means that the documents will contain metadata and could be altered by the other side. The panel suggested producing materials in both their native format and hard copy or .pdf format so that alterations can be detected.

Outside vendors might be needed to help gather and produce electronic data. If this is the case, the panel recommended using a single outside vendor who understands the firm rather than using multiple vendors. Hiring a discovery specialist might help.

Some firms try to reduce costs by simply producing all electronic documents without prior review after reaching an agreement with opposing counsel that the production will not waive the attorney-client privilege. This practice is by no means risk-free. Once someone learns privileged information, there is no erasing that knowledge. Moreover, the privilege may be waived if the producing party does not make a prompt request for the return of privileged materials. For these reasons, some panel members strongly discouraged this approach.

Attempting to shift the cost of electronic discovery to the other side may be a way to deter broad electronic discovery requests, but this has not been tried often enough to evaluate whether it can be an effective strategy.

The technology underlying storage and retention of electronic documents is quickly changing. The e-mail backup tapes that have led to document retention sanctions, such as in Coleman (Parent Holdings) Inc. v. Morgan Stanley, Inc., 2005 WL 674885 (Fla. Cir. Ct., March 23, 2005), may be starting to disappear as those systems are being replaced by automatic data retention systems. These data retention systems are designed to eliminate the possibility that electronic data could be deleted.

The timing of the SIA seminar could not have been better for the purposes of discussing key developments in securities-related civil litigation. The Supreme Court issued its decision in Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 2006 WL 694137 (U.S.), on Tuesday while the conference was in full swing. In Dabit, the Court held that the Securities Litigation Uniform Standards Act of 1998 (SLUSA) not only preempts state-law covered class actions brought by purchasers and sellers of securities, but also preempts those brought by "holders" of securities.

Attendees also discussed other developments in securities litigation over the past year, including the Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 125 S. Ct. 1627 (2005). In Dura Pharmaceuticals, the Court resolved a split in the circuits and held that a plaintiff cannot satisfy the loss causation element in a fraud on the market claim by proving merely that the price of the security was inflated on the date of purchase. Rather, to prevail, a plaintiff must prove that "the defendant’s misrepresentation (or other fraudulent conduct) proximately caused the plaintiff’s economic loss." Id. at 1633.

The session on Major Liabilities left no doubt in anyone’s mind about the importance of this topic. In 2005, securities defendants paid out approximately $16.5 billion to settle class action lawsuits, the panel noted.

This session included a discussion of a new strategy that the plaintiffs bar may use in an effort to impose liability on defendants who are not directly involved in the conduct at issue. Ever since the Supreme Court put an end to "aiding and abetting" liability in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), plaintiffs have been looking for a way to fill the void. Panelists pointed to a recent decision from the Southern District of New York, In re: Parmalat Securities Litigation, 376 F. Supp. 2d 472 (S.D. N.Y. 2005), as one that the plaintiffs bar might cite in support of an argument that those who are secondary (at best) actors should be held liable because they supposedly acted as part of the "scheme" to defraud. This language, of course, comes directly from Rule 10b-5, which prohibits "any device, scheme, or artifice to defraud" investors. Under this approach, defendants who would have been alleged to have been "aiding and abetting" prior to Central Bank would now be alleged to have been participating in the "scheme," even though the conduct at issue is the same. Panel members observed that it is unclear whether this blatant effort to make an end run around Central Bank will be successful.

In addition to "scheme liability," the panelists also discussed the impact that regulatory and white collar cases have been having on the civil cases that follow regulatory investigations. For example, in January 2006, the SEC issued a statement identifying the factors it considers important when deciding whether to impose financial penalties in a particular case. They are: (1) whether or not the wrongdoing provided a "direct benefit" to the corporation and/or broker-dealer; and (2) whether the penalty will provide compensation, or simply cause greater harm, to the injured shareholders. Regardless of whether these factors will reduce the size of regulatory fines in any given case, they do provide a framework from which defense counsel can argue the point, panel members noted.

Panel members mentioned another development that could temper the SEC’s current enthusiasm for imposing large penalties. They noted that the General Accounting Office has reported that only a tiny fraction of the $4.8 billion in penalties imposed has been dispersed to alleged "victims." The "fair fund" provision of the Sarbanes-Oxley Act requires the Commission to deposit penalty money in a victims compensation fund. The fact that the Commission seems to be unable to carry out this provision may bolster defense attorneys’ arguments against the imposition of large regulatory fines, panelists observed.

In a somewhat related development, panel members pointed out the value of filing a motion to strike when plaintiffs include extraneous and irrelevant allegations about regulatory settlements in their complaint, which seems to be happening on a regular basis lately. Some courts have been willing to grant defendants’ motions to strike these allegations. See, e.g., Gotlin v. Lederman, 367 F. Supp. 2d 349 (S.D.N.Y. 2005). As a result, the motion to strike is becoming a good defensive tool to lessen the impact and use of regulatory settlements in civil litigation.

After watching the destruction of the Arthur Andersen accounting firm following its indictment, the Department of Justice has been making greater use of deferred prosecution agreements. Although a deferred prosecution agreement may help limit the impact on the firm involved, the agreement generally requires the firm to accept responsibility for the underlying act. According to the panel, defense counsel should push for non-prosecution agreements, in which responsibility is generally not accepted.

Another issue discussed by the panel in this session was the production of confidential documents to a third party, specifically in connection with the production of documents to a regulator. In the case of In re Natural Gas Commodities Litigation, 232 F.R.D. 208 (S.D.N.Y. 2005), the district court agreed with the magistrate judge that the defendant’s voluntary production of documents to several governmental agencies did not constitute a general waiver of the attorney-client and/or work product privilege in all future actions. This is consistent with Second Circuit precedent but is not the rule in most circuits. In the Second Circuit, it is of the utmost importance to get a confidentiality agreement in place before producing privileged material to a regulator. However, most other circuits have held that once the privilege has been waived by the production of documents to regulators, it has been waived across the board.

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.