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What anti-money laundering compliance programs should financial firms have in place? The Financial Industry Regulatory Authority ("FINRA") recently announced that it had fined Credit Suisse Securities (USA) LLC, a former unit of Credit Suisse AG, $16.5 million for anti-money laundering ("AML"), supervision, and other violations. The self-regulatory watchdog found that the firm's monitoring program for detecting suspicious activity was deficient in two material ways. First, Credit Suisse primarily relied on its registered representatives to identify and escalate potentially suspicious trading, including in microcap stock transactions. That reliance, however, was misplaced as representatives did not always escalate and investigate high-risk activity, as required. Second, the firm failed to properly implement its automated surveillance system, which was set up to detect, and monitor for, suspicious money transfers. FINRA found that a significant portion of the data feeds into the system were missing information or had other issues that compromised the effectiveness of the system. Credit Suisse also failed to use certain scenarios designed by the system to identify common suspicious patterns and activities, and failed to adequately investigate activity identified by the scenarios that the firm did use. "It’s critical that firms have effective AML systems in place so that they can comply with their obligations to review and report suspicious transactions, including those involving trading in microcap securities or potentially suspicious money transfers,” said Brad Bennett, FINRA's Executive Vice President and Chief of Enforcement. According to the announcement, from January 2011 through September 2013, Credit Suisse failed to effectively review trading for AML reporting purposes. The firm expected its registered representatives, who were the primary contact with the customers, to identify and report unusual or suspicious activities or transactions ( i.e. , activities and transactions described in Credit Suisse’s AML policies as red flags) to the firm's AML compliance department. In turn, the compliance department was required to investigate the activity or transaction, document its findings and file Suspicious Activity Reports ("SARs") where appropriate. However, the systems and procedures the firm used to monitor trading for other purposes were not designed to detect potentially suspicious activity from an AML perspective and the other departments and branches of the firm did not assume responsibility for reviewing trading for AML reporting purposes.  As a result, in certain circumstances, Credit Suisse did not investigate suspicious trading adequately to assess whether a SAR should be filed. In addition, Credit Suisse’s reliance on representatives to escalate potentially suspicious trading failed to account for the fact that most orders it received from its foreign affiliates came in to the firm electronically and thus were not seen by the firm’s sales traders. FINRA also found that from January 2011 through December 2015, Credit Suisse failed to effectively review suspicious money transfers. The firm used an automated surveillance system to identify red flags of suspicious activity. Credit Suisse failed to implement the automated surveillance system properly by, among other things, inadequately inputting the data into the system, and failing to use available scenarios that were applicable to the money-laundering risks presented by its business. Although Credit Suisse self-identified some of the deficiencies and retained a consulting firm to assist in evaluating them, the firm initially failed to devote adequate resources to resolve the issues in a timely fashion, and some of the deficiencies remain unresolved today. In addition, FINRA found that Credit Suisse did not have adequate staffing to review the tens of thousands of alerts the automated system generated in any given year. Finally, FINRA found that Credit Suisse’s supervisory systems and conrols were deficient as it relates to compliance with the prohibition of the sale of unregistered securities. Certain Credit Suisse customers deposited and sold microcap stock through the firm, which should have raised red flags indicating that the shares were potentially part of an illegal distribution. The firm failed to instruct its representatives on how to determine whether those securities were registered or subject to an exemption from registration prior to executing those trades. As a result, Credit Suisse facilitated the illegal distribution of at least 55 million unregistered shares of securities. The firm subsequently implemented additional procedures limiting the trading of microcap securities. Credit Suisse said in a statement that it had cooperated with FINRA's inquiry, and that the firm had been taking "appropriate internal remedial efforts.” In addition to the fine, Credit Suisse agreed to adopt and implement policies and procedures within 90 days to address the problems cited in the letter of Acceptance, Waiver and Consent (which can be found  here ). Credit Suisse neither admitted nor denied the charges but did agree to FINRA's findings. The Takeaway This case illustrates the need for FINRA member firms to have sufficient AML compliance programs in place since money laundering and other suspicious activity is often concealed in securities transactions, particularly in microcap stocks. Not only can compliance violations result in significant fines, such deficiencies could also trigger a wider securities investigations.

On December 14, 2016, the Department of Justice (“DOJ”) announced that it “obtained more than $4.7 billion in settlements and judgments from civil cases involving fraud and false claims against the government” in the fiscal year ended September 30, 2016. This amount represents “the third highest annual recovery in False Claims Act history, bringing the fiscal year average to nearly $4 billion since fiscal year 2009, and the total recovery during that period to $31.3 billion.” According to the DOJ, more than one-half of the recoveries ( i.e. , $2.5 billion of the $4.7 billion) came from the health care industry, including drug companies, medical device companies, hospitals, nursing homes, laboratories, and physicians.  The DOJ did not, however, include in the total recoveries for state Medicaid programs, although the Department was “instrumental” in obtaining those monies. For the seventh consecutive year, the DOJ has recovered in excess of $2 billion due to whistleblower information about health care fraud. “The next largest recoveries came from the financial industry in the wake of the housing and mortgage fraud crisis.”  The government recovered “nearly $1.7 billion in fiscal year 2016” from “ ettlements and judgments in cases alleging false claims in connection with federally insured residential mortgages.” This amount is “the second highest annual recovery in this area.” Recoveries in Whistleblower Suits The FCA prohibits businesses and individuals from defrauding the government by knowingly presenting, or causing to be presented, a false claim for payment or approval. The FCA rewards whistleblowers who successfully recover funds on behalf of the government. In 1986, Congress strengthened the FCA by increasing the incentives for whistleblowers to file lawsuits alleging false claims on behalf of the government. The FCA has proven to be one of the most effective laws used to recover taxpayer money fraudulently taken from the government. In fiscal year 2016, whistleblowers filed 702 qui tam lawsuits; the DOJ “recovered $2.9 billion in these and earlier filed suits” during the fiscal year.  Whistleblowers received $519 million from the government during the same period. Since 1986, “ he number of lawsuits filed under the qui tam provisions of the has grown significantly.” Since 2009, this growth has been even more dramatic, leading to an increase in recoveries.  “From January 2009 to the end of fiscal year 2016, the government recovered nearly $24 billion in settlements and judgments related to qui tam suits and paid more than $4 billion in whistleblower awards during the same period.” “The qui tam provisions provide a valuable incentive to industry insiders who are uniquely positioned to expose fraud and false claims to come forward despite the risk to their careers,” said Principal Deputy Assistant Attorney General Mizer.  “This takes courage, for which they are justly rewarded under the Act.” Takeaway: This success of this year’s recoveries demonstrates the importance of whistleblowers in the government’s fight against fraud and false claims. Indeed, whistleblowers are vital to the process and its overall success – approximately $53.1 billion has been recovered since the 1986 amendments. Senator Chuck Grassley, who authored those amendments, underscored this point in response to the DOJ’s announcement: “For those who doubt the value of whistleblowers and the False Claims Act, when it comes to fraud against the government, I’d say at least $53 billion, and counting.” There is not, and will not be, a shortage of people who try to defraud the government. Given the success of the government’s efforts during fiscal year 2016, it is more than likely the DOJ will continue to root out fraud and abuse in fiscal year 2017 by using information obtained from whistleblowers and whistleblower lawsuits. As such, the FCA will remain, as Senator Grassley observed, “the single most effective tool to recovering taxpayer dollars lost to fraudsters who exploit the government.”  The FCA works, and the recoveries prove it.

The Securities and Exchange Commission (“SEC” or “Commission”) has put a lump of coal in the Christmas stockings of two companies this week for using separation agreements that impede the ability of whistleblowers to report violations of the securities laws to the Commission. The announcements by the SEC ( here and here ) came within a day of each other and evidence a continued resolve by the Commission to crackdown on companies that use severance agreements and other types of employment contracts to silence and discourage employees from reporting wrongdoing to the Commission. The settlements announced on December 19 and 20 follow a string of cases (four of which were discussed by this Blog here and here ) brought by the SEC against companies within the past 24 months that have used severance agreements to impede departing employees from communicating with the SEC about possible securities law violations—agreements that, among other things, impose financial forfeiture on the employee or expose the employee to litigation. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or the “Act”) to combat illegal and fraudulent conduct on Wall Street and promote compliance with the federal securities laws.  The Dodd-Frank Act contains whistleblower provisions that authorize the SEC to pay substantial cash rewards to whistleblowers that voluntarily provide the SEC with information about violations of the securities laws. The Act further empowers whistleblowers to report corporate fraud or illegal conduct by prohibiting retaliation against individuals who blow the whistle under the SEC whistleblower program. In 2011, the SEC adopted Rule 21F-17 to implement the whistleblower-protection provisions of the Act.  The rule provides that “ o person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement … with respect to such communications.” Rule 21F-17 applies to any policy or procedure, or agreement, such as confidentiality, severance, and non-disclosure agreements, that may impede an employee or former employee from providing information to the SEC about a securities law violation. In February 2015, the SEC began policing confidentiality agreements and punishing those companies that used such agreements to impede whistleblowing communications with the Commission. The enforcement division asked dozens of public companies for nondisclosure agreements, employment contracts, severance agreements, and other similar documents as part of an investigation into whether there were efforts to suppress lawful whistleblowing activities. By April of that year, the SEC brought its first action. In addition to initiating enforcement actions, the staff of the Office of Compliance Inspections and Examinations has warned companies that it is reviewing compliance with the Commission’s rules and “encouraged” the companies to “to evaluate whether their compliance manuals, codes of ethics, employment agreements, severance agreements, and other documents contain language that may be inconsistent with Rule 21F-17.” See October 24, 2016 “Risk Alert” . The Latest Settlements: NeuStar, Inc. : On December 19, 2016, the SEC announced that NeuStar, Inc., a Virginia-based technology company, agreed to pay a $180,000 penalty “to settle charges involving its severance agreements,” which the SEC charged “impeded at least one former employee from communicating information” to the Commission. The SEC found that NeuStar violated Rule 21F-17 “by routinely entering into severance agreements that contained a broad non-disparagement clause forbidding former employees from engaging with the SEC and other regulators ‘in any communication that disparages, denigrates, maligns or impugns’ the company.”  Violation of the provision could result in the forfeiture of all but $100 of the employee’s severance pay. According to the SEC, these severance agreements were used with at least 246 departing employees from August 12, 2011 to May 21, 2015. NeuStar voluntarily revised its severance agreements after the SEC began its investigation and consented to the SEC’s cease-and-desist order without admitting or denying the findings. In addition, NeuStar agreed to make reasonable efforts to inform those who signed the severance agreements that the company does not prohibit former employees from communicating any concerns about potential violations of law or regulation to the SEC. SandRidge Energy Inc. : On December 20, 2016, the SEC announced that an Oklahoma City-based oil-and-gas company, SandRidge Energy Inc., “agreed to settle charges that it used illegal separation agreements” and illegally “retaliated against a whistleblower who expressed concerns internally about how reserves were being calculated.” The SEC found that although SandRidge conducted multiple reviews of its separation agreements after Rule 21F-17 became effective in August 2011, it nevertheless “continued to regularly use restrictive language that prohibited outgoing employees from participating in any government investigation or disclosing information potentially harmful or embarrassing to the company.” Such restrictive language, charged the SEC, violated the very rule the company “regularly” reviewed. The SEC further found that SandRidge fired a whistleblower who repeatedly raised concerns internally about the process used by SandRidge to calculate its publicly reported oil and gas reserves.  That employee, who had been offered a promotion, but turned it down, was fired months later after senior management concluded the employee was disruptive and could be replaced with someone “‘who could do the work without creating all the internal strife.’” The company had conducted no substantial investigation of the whistleblower’s concerns and initiated an internal audit that was never completed. This was the first time the SEC has charged a company “for retaliating against an internal whistleblower,” said Jane Norberg, Chief of the SEC’s Office of the Whistleblower. The employee’s separation agreement also contained the company’s prohibitive language that violated the whistleblower protection rule. SandRidge agreed to pay a penalty of $1.4 million, subject to the company’s bankruptcy plan, without admitting or denying the SEC’s findings. David A Kimmel, director of communications for SandRidge, said in an email statement that under the company’s bankruptcy reorganization plan, SandRidge will satisfy the fine by a payment of about $100,000. Takeaway: In commenting on the NeuStar settlement, Jane Norberg stated that the SEC’s action demonstrated its “continued” enforcement of Rule 21F-17, and “underscore ” the Commission’s “ongoing commitment to ensuring that potential whistleblowers can freely communicate with the SEC about possible securities law violations.” It fair to say that “strong enforcement” of the rule will remain a priority of the Commission during 2017. In light of this “continued” enforcement effort, companies should review their severance, confidentiality and employment agreements to ensure compliance with Rule 21F-17. To be sure such agreements and documents are important tools for companies to protect their sensitive information.  But, they should not be used as a shield to thwart the disclosure of wrongdoing. Therefore, agreements that are vague and ambiguous about the ability of departing employees to report wrongdoing to the SEC should be revised to make it clear that communications with the SEC are not prohibited.

New York, NY ( Law Firm Newswire ) December 22, 2016 -  The Law Office of Jeffrey M. Haber is pleased to announce that Mr. Haber has once again been named by Super Lawyers magazine to be among the top lawyers in the New York metropolitan area. The Law Office of Jeffrey M. Haber was recognized in the 2016 Super Lawyers, Business Edition (an annual guide to the nation’s top business law firms and attorneys) for his business litigation work. As part of his history of professional achievements, he was also recognized as a Super Lawyer in the Super Lawyers, Business Edition in 2011, 2013, 2014, and 2015. Super Lawyers magazine is an affiliate of Thomson Reuters. The publication recognizes attorneys who have distinguished themselves by both a high degree of professional achievement and by peer recognition. Each year, no more than 5 percent of lawyers are recognized as Super Lawyers by the magazine. The annual selection involves a survey of lawyers, independent research evaluation of candidates, and peer reviews within each practice area. The magazine publishes its lists nationwide, as well as in leading city and regional magazines and newspapers across the country. A description of the selection process can be found on the Super Lawyers website . About The Law Office of Jeffrey M. Haber Located in New York City, The Law Office of Jeffrey M. Haber is dedicated to representing corporations, small businesses, partnerships and individuals engaged in a broad range of business and litigation matters. For over 25 years, The Law Office of Jeffrey M. Haber have been involved in high-profile, complex litigations and arbitrations and has served in various roles in both individual and class action lawsuits which have resulted in million and multimillion-dollar settlements and awards. His practice combines the sophistication and counsel of a large national law firm with the economy, flexibility, commitment, and personal attention of a small firm. ATTORNEY ADVERTISING. © 2016 The Law Office of Jeffrey M. Haber. The law firm responsible for this advertisement is The Law Office of Jeffrey M. Haber, 708 Third Avenue, 5th Floor, New York, New York 10017, (212) 209-1005. Prior results do not guarantee or predict a similar outcome with respect to any future matter. Contact: The Law Office of Jeffrey M. Haber 708 Third Avenue, 5th Floor New York, N.Y. 10017 Tel: (212) 209-1005 Fax: (212) 209-7101 Email: info@jhaberlaw.com

Perpetrating a fraud on the government is a serious problem. It has economic and life threatening consequences ( e.g. , increasing costs to taxpayers, and providing defective bullet proof vests to the military). Congress and the states have passed many laws to end fraud on the government. Chief among these is the False Claims Act (“FCA”) and the state analogues. The FCA imposes liability on persons and companies who defraud the government and protects and rewards whistleblowers who come forward with information that expose the wrongdoing. One of the FCA’s most ardent proponents is Senator Chuck Grassley (R-IA). Earlier this month, Senator Grassley was at the forefront of legislation passed by the Senate that increases the protections for whistleblowers. These bills, two of which he sponsored and/or co-sponsored, protect whistleblowers who report information to the office of the inspectors general, extend protections to employees of government subcontractors and grantees, and permit FBI employees to report wrongdoing to their direct supervisors.  These bills are discussed below. Whistleblower Protection for Contractor and Grantee Employees Act: On December 5, the Senate passed S. 795 , legislation sponsored by Senator Claire McCaskill, that gives subgrantees and personal services contractors the same whistleblower protections currently given to contractors, grant recipients, and subcontractors, and prohibits contractors from being reimbursed for legal fees accrued in their defense against retaliation claims by whistleblowers. The bill also would make protections for civilian contractors and grantees permanent – protections that contractors and grantees of the Department of Defense already enjoy. “We’ve got an enormous contracting workforce in the federal government, and we’ve got to make sure that all of our contractors have the same whistleblower protections as the government employees they work alongside—because these folks are the ones raising the alarm on waste, fraud, and abuse of power,” said Senator McCaskill. The legislation became law on December 14, 2016. Inspector General Empowerment Act of 2016: On December 10, the Senate passed H.R. 6450 , the Inspector General Empowerment Act of 2016. Co-sponsored in the Senate by Senator Grassley, the legislation will expand the tools for inspectors general to identify and address fraud, waste and misconduct in government.  The act restores Congress’ intent to guarantee inspectors general access to “all records” of the agencies they oversee, overturning a July 2015 opinion from the Department of Justice’s Office of Legal Counsel that stated otherwise. The House of Representatives passed identical legislation earlier that week. The Senate version of the bill was introduced by Senator Grassley, who stated the following about the legislation: “If we’ve learned one thing in the last year, it’s that government needs more transparency and oversight, not less.  Inspectors general are our eyes and ears in government.  They are on the front lines in the fight against fraud, waste and misconduct, but they can’t do their job if they can’t access the necessary government documents.  This bill makes sure that they have the tools and access they need to safeguard our tax dollars, improve efficiency, and tackle misconduct.” “Passage of the IG Empowerment Act enhances the IGs’ ability to fight waste, fraud, abuse and misconduct, protects whistleblowers who share information with IGs, increases government transparency and bolsters the public’s confidence in the independence of IGs,” said Justice Department Inspector General and CIGIE Chair Michael Horowitz. “For these reasons, the act is an important milestone for good government. The inspector general community is grateful to the sponsors and co-sponsors of this act and all those who stood up for independent oversight.” The legislation is awaiting President Obama’s signature. Federal Bureau of Investigation Whistleblower Protection Enhancement Act of 2016: On December 10, the Senate passed H.R. 5790 , the Federal Bureau of Investigation Whistleblower Protection Enhancement Act of 2016. H.R. 5790 was introduced as a companion to S. 2390, the Federal Bureau of Investigation Whistleblower Protection Enhancement Act of 2015, which was introduced in the Senate on December 10, 2015 by Senators Grassley and Leahy. The 2015 Senate bill attempted to reform the FBI whistleblower protection system by changing the process for investigating and adjudicating claims of retaliation by employees who report fraud, abuse and waste. For example, it would have strengthened the appeals process for whistleblowers by requiring appellate review by the Attorney General and giving employees access to the courts. It would have defined prohibited personnel practices to be consistent with those of other Federal employees, and it would have prohibited the use of nondisclosure agreements unless the employee was fully aware of his/her rights before signing such an agreement. Currently, FBI employees are not protected when they disclose wrongdoing to their supervisors.  Instead, Justice Department regulations require disclosures to be made to a limited group of senior officials even though FBI policy encourages employees to report to supervisors.  Thus, FBI whistleblowers often make their initial disclosure to a supervisor, but have no legal protection in the event of retaliation. H.R. 5790 represents a modification of the 2015 Senate version. If signed by the President, H.R. 5790 will allow FBI employees to report abuse, fraud, and waste to their direct supervisors, as well as to the Inspector General of the Department of Justice and the Office of Special Counsel; change the process for investigating and adjudicating complaints regarding reprisals against whistleblowers; and require the Department of Justice and the Government Accountability Office to prepare reports related to complaints of whistleblower retaliation and the handling of those cases by the FBI. “This is a really important provision for the patriotic men and women at the FBI who have gone without the whistleblower protections given to other federal employees for far too long.  The current process is vague, confusing and lacks common sense, and it often puts people in hot water for no legitimate reason,” said Senator Grassley. “The protections in this bill ensure a logical reporting requirement which allows more cases to be heard on the merits instead of being senselessly dismissed because an FBI employee logically reported wrongdoing to their supervisor.”  He also stated that he will pursue the remaining provisions of the Senate version of the act in the next Congress. On December 15, the bill was presented to President Obama for signature. Takeaway: In a statement to Congress on July 8, 2016, Senator Grassley highlighted the integral role of whistleblowers in the fight against fraud on the government. The legislation discussed in this article, which he helped to shepherd through the Senate, signals the government’s continued commitment to support and encourage whistleblowers, whose efforts save taxpayers billions of dollars each year and lead to a more accountable government, to come forward with information that discloses fraud and other wrongdoing on the government.

On December 6, 2016, the United States Supreme Court ruled that a violation of the seal provisions of the False Claims Act (“FCA”) does not mandate dismissal of a relators’ complaint. In doing so, the Court affirmed the judgment of the Fifth Circuit, which, in turn, affirmed the judgment of the district court. In State Farm Fire & Casualty Co. v. United States Ex Rel. Rigsby (which this Blog wrote about here and here ), whistleblowers, Cori and Kerri Rigsby, filed a qui tam action against State Farm accusing the insurer of defrauding the government by falsely classifying wind damage caused by Hurricaine Katrina as flood damage. Prior to Hurricane Katrina, State Farm issued homeowner-insurance policies that included both flood and wind damage. The flood insurance was backed by the National Flood Insurance Program, while State Farm’s own general homeowner’s policies covered wind damage.  This meant that policyholders affected by Hurricane Katrina would receive compensation from the government for flood damage, while State Farm would be responsible for damage cause by the wind.  According to the relators, the insurer instructed its adjusters to falsely classify wind damage as flood damage in order to shift the cost of insurance payouts to the federal government. The Rigsby sisters, claims adjusters for State Farm, filed a qui tam complaint under seal, alleging that the insurer wrongfully sought to maximize their policyholders’ flood claims in order to minimize its exposure to wind damage claims. Prior to the seal being lifted, counsel for the sisters leaked news of the existence of the complaint to media outlets who published stories about the alleged fraud.  State Farm moved to dismiss the complaint, arguing that the relators’ violation of the seal requirement mandated the dismissal of the complaint.  It did not, however, request a lesser sanction. The district court found that dismissal was not warranted, applying a balancing test that looked at three factors: (1) actual harm to the government; (2) the severity of the violations; and (3) evidence of bad faith.  The case went to trial, resulting in a victory for the Rigsby sisters. The Fifth Circuit affirmed, and found that a seal violation does not mandate dismissal. The Supreme Court granted certiorari and affirmed. The Supreme Court’s Ruling: In declining to require dismissal of a complaint for violating the seal requirement, the Court found that the FCA did not require such a harsh result. The Court noted that the language of the seal provision only creates a mandatory rule the relator must follow, it does not say anything “about the remedy for a violation of that rule.” Slip op. at 6. As such, “the sanction for breach is not loss of all later powers to act.” Id . (citation and internal quotation marks omitted). The Court found support for this finding in the structure of the FCA itself. The Court observed that the FCA contains several provisions requiring, in express terms, the dismissal of a relator’s action. E.g. , §§ 3730(b)(5), (e)(1)–(2). The seal provision is not one of them. Since the Court refrains from inferring the “explicit” limitations found in other provisions of the statute to the one under review, it concluded that Congress did not intend to require dismissal for a violation of the seal requirement. Id . at 7. This result, said the Court, was consistent with the general purpose of the seal provision, which was enacted to “encourage more private enforcement suits,” and protect the Government’s interests in pursuing investigations without the knowledge of the defendants. Id . (citing S. Rep. No. 99–345, pp. 23–24). Thus, “it would make little sense to adopt a rigid interpretation of the seal provision that prejudices the Government by depriving it of needed assistance from private parties.” Id . Further, the Court found that the seal provision provides no textual indication that Congress “conditioned the authority to file a private right of action on compliance with statutory mandate.”  Id . at 8. In fact, said the Court, there is no textual reason to tie the relator’s ability to bring an action on his/her adherence to the seal requirement. While dismissal is not the mandatory remedy, the Court stated that a district court could order dismissal in the exercise of its discretion if the circumstances warranted it and suggested that the factors set forth by the Ninth Circuit in United States ex rel. Lujan v. Hughes Aricraft Co . “appear to be appropriate” for that consideration. Id . at 10. In Lujan , the Ninth Circuit considered such factors as whether the Government was actually harmed by the disclosure, Congressional intent to encourage litigation through qui tam actions, and the presence or absence of bad faith or willfulness of the disclosure. The Court declined to “explore” those factors “and other relevant considerations,” leaving it to “later cases” to decide the “standards” to apply when determining whether dismissal of a qui tam complaint is the proper remedy for a violation of the seal provision. Id . at 10. Finally, the Court ruled that the district court did not abuse its discretion in denying State Farm’s motion to dismiss. The Court did not consider whether lesser sanctions were appropriate in the case because State Farm requested no other sanction than dismissal. As a result, the question was not preserved. Accordingly, the Fifth Circuit’s judgment was affirmed. The Court’s opinion is available here:  https://www.supremecourt.gov/opinions/16pdf/15-513_43j7.pdf . Takeaway: In this Blog’s first article on the case, we indicated that the Ninth Circuit’s balancing approach was the most reasonable: “Balancing the violation, the reason for the violation and the impact of the violation on the government’s investigative interests seems to be the most reasonable way to ensure that meritorious cases are not dismissed over a technicality.” Although the Court did not specifically adopt the approach, it cited the approach with approval for the lower courts to use as a guidepost in determining whether dismissal is the appropriate remedy. This Blog continues to believe that the Ninth Circuit approach is the appropriate one and should serve as the guidepost for future cases. Since the Court declined to rule out dismissal as a possible remedy for violating the seal requirement, parties should be aware that dismissal is still on the table. Thus, while the Court’s decision can be considered a win for relators, whistleblowers who wish to bring a false claim action should, nevertheless, avoid disclosing the suit to the public.  By the same token, defendants who learn through public sources that they are facing a qui tam action should identify the actual harms they incurred because of the disclosure. Since mandatory dismissal is not an option, both sides will be well advised to remember that the remedy to be assessed rests in the sound discretion of the court.

In a December 2016 regulatory notice to member firms, the Financial Industry Regulatory Authority (“FINRA”) announced that the Securities and Exchange Commission (“SEC”) approved amendments to Rule 12403 of the Code of Arbitration Procedure for Customer Disputes. The amended rule will increase (1) the number of arbitrators on the public arbitrator list that FINRA sends to parties during the panel selection process from 10 to 15, and (2) the number of strikes to the public arbitrator list from four to six, so that the proportion of strikes is the same under the amended rule as it is under the current rule. Prior to the rule change, FINRA provided customers with a choice between two methods for the selection of a three-person panel. The first method, the Majority-Public Panel Option, provided for a panel of one chair-qualified public arbitrator, one public arbitrator and one non-public arbitrator. Prior to February 1, 2011, this option was FINRA’s only method for the selection of three-member panels. The second method, the All-Public Panel Option, which was added on February 1, 2011, permits any party to select a panel consisting of three public arbitrators. Customers were given the option of choosing this method of selection in their statement of claim or within 35 days from service of the statement of claim. In the absence of a customer’s selection, by default, the Majority-Public Panel Option would apply. Following implementation of the All-Public Panel Option, FINRA reviewed arbitrator ranking data and awards to determine whether the All-Public Panel Option was having the intended result – to eradicate the perceived bias in favor of the securities industry in cases involving three arbitrators and enhance confidence in and increase the perception of fairness in the arbitration process.  FINRA found that in approximately 75% of the eligible cases, customers chose the All-Public Panel Option. Customers using the Majority-Public Panel Option did so by default 77% of the time, rather than making an affirmative choice. FINRA also found that the choice of selection method had an impact on the awards issued by its panels: namely, customers were awarded damages significantly more often when an all-public panel presided over their case. Moreover, FINRA’s review led to its concern that pro-se litigants and attorneys unfamiliar with the selection process would inadvertently end up with a mixed-panel without understanding the significance of that panel composition. Based on, among others, these findings and concerns, FINRA proposed the amendments to Rule 12403. The amendments will become effective for all arbitrator lists FINRA sends to parties on or after January 3, 2017, for panel selection in customer cases with three arbitrators. The text of the amendments is set forth in the attachment to the notice. Takeaway: The amended rule provides the parties with greater choice in the selection of public arbitrators during the panel selection process. By increasing the number of qualified public arbitrators to be ranked, the amended rule should minimize the selection of arbitrators by FINRA without the parties’ input (also known as cramdown arbitrators). At bottom, the amended rule should improve the parties’ ability to select a panel that they feel is most appropriate to resolve their dispute (i.e., a panel of all public arbitrators), while increasing the perception that the arbitration process is fair and equitable.

Over the year, this Blog has written about awards given to whistleblowers under the SEC and CFTC whistleblower programs – the anti-fraud/anti-corruption programs created under the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). See here , here , here , here , and here . As this Blog previously reported, on December 5, 2016, the SEC announced that it had awarded $3.5 million to a whistleblower who came forward with information that led to a successful SEC enforcement action.  Just four days later, on December 9, the SEC once again announced that it had awarded money under its bounty program – nearly $1 million – to a whistleblower “whose tip enabled the SEC to bring multiple enforcement actions against wrongdoers.” The whistleblower is the 37 th relator to receive an award under the SEC whistleblower program. In total, since 2011, the SEC has paid approximately $136 million to whistleblowers who provided information resulting in the collection of monetary sanctions against violators of the securities laws. To date, the SEC has recovered more than $874 million from enforcement actions resulting from whistleblower tips. The SEC declined to identify the whistleblower or the wrongdoers. By law, the SEC protects the confidentiality of whistleblowers and does not release information that might directly or indirectly reveal the whistleblower’s identity. Commenting on the award, Jane Norberg, Chief of the SEC’s Office of the Whistleblower, stated: “With the issuance of this second award in less than one week, we hope to continue to encourage individuals to submit high-quality tips that we can leverage to enforce the law and protect investors, and they can receive significant financial rewards for their valuable contributions to a case.” Under the program, whistleblowers are eligible for an award if they voluntarily provide the SEC with original information that leads to a successful enforcement action that exceeds $1 million. The award can range from 10 percent to 30 percent of the money collected. All payments come from an investor protection fund established by Congress that is financed through monetary sanctions paid to the SEC by securities law violators.  No money is taken or withheld from harmed investors to pay whistleblower awards. Takaway: As the SEC continues to use its bounty program to provide financial rewards to whistleblowers, more and more whistleblowers have come forward with information that has led to successful enforcement proceedings.  As Jane Norberg’s comments indicate, the bounty provisions of the whistleblower program have played an important role in the SEC’s efforts to encourage people with information about violations of the securities laws to come forward and report them to the Commission. This Blog hopes that whistleblowers will continue to come forward, especially since the program is under the microscope of the new administration (discussed by this Blog here ).

Let’s say you, the reader, are an entrepreneur who wants to open a business. Although you are willing to run the risks associated with a startup, you do not want to incur any personal liability for the acts done by the business.  After speaking with your family, friends and neighbors, you decide to incorporate the business. The consensus view is that a corporate entity, such as a corporation or limited liability corporation (“LLC”), will enable you to operate the business and shield yourself from any personal liability caused by the acts of the company. After all, they tell you, entrepreneurs form such entities all the time. Taking the advice of those with whom you consulted, you incorporate your business as an LLC. You hire an attorney who helps you with the incorporation. He also warns you that although you incorporated the business, you are not necessarily insulated from personal liability for the acts of the company or LLC.  The reason you remain at risk, he explains, is because creditors, among others, can pierce the corporate veil (that is, lift the corporation or LLC’s veil of limited liability). Corporate Liability for Business Debts: Corporations and LLCs are separate and distinct legal entities, independent of the people who form and own them. The owners of these entities are normally not liable for the debts incurred by the corporation or LLC. However, in certain circumstances, courts will ignore the corporate form and hold the officers, directors, and shareholders or members personally liable for the company’s fraudulent or dishonest acts. When this happens, it is called piercing the corporate veil. Effects of Piercing the Corporate Veil: If a court pierces the corporate veil, then the company’s owners, shareholders, or members will be held personally liable for the company’s wrongdoing. This means that the company’s creditors, among others, can go after the owners’ home, bank account, investments, and other assets to satisfy the company’s debt. The courts will not, however, impose personal liability on individuals who are not responsible for the company’s wrongful or fraudulent activities; only those parties responsible for the wrongful conduct will be held liable for the company’s debts. Courts Will Pierce the Corporate Veil Under Certain Circumstances: In general, the courts will pierce the corporate veil and impose liability on the company’s owners, shareholders, or members when: (1) the owners, shareholders, or members exercised complete domination over the corporation or LLC; and (2) the owner’s domination of the corporation or LLC was used to commit a fraud or wrong that injured another. There is No Daylight Between the Company/LLC and its Owner. Domination of the corporation or LLC by its owners, shareholders or members is not by itself sufficient to pierce the corporate veil. Still, it is a necessary element. The plaintiff must prove that the owner, shareholder or member is operating the corporation or LLC as a “sham” for his/her personal benefit and the corporation or LLC is acting as the “agent,” “alter ego” or “mere instrumentality” of the owner, shareholder or member. Conclusory allegations of domination and control are insufficient. The plaintiff must come forward with facts demonstrating that there was such a unity of interest and control between the defendant and the other entity that they cannot really be said to be two separate entities. Indicia of domination includes, among others: (1) the failure to adhere to corporate formalities (such as, making important corporate or LLC decisions without recording them in minutes of a meeting); (2) inadequate capitalization (that is, the corporation or LLC never had sufficient funds to operate; it was not a separate entity that could stand on its own); (3) a commingling of assets; (4) one person or a small group of closely related people were in complete control of the corporation or LLC; and (5) use of corporate funds for personal benefit ( e.g. , the owner, shareholder or member pays his/her personal bills from the business checking account). The company’s actions were wrongful or fraudulent. In New York, it is not necessary to plead or prove fraud in order to pierce the corporate veil. Those seeking to pierce the corporate veil must show that the corporation or LLC was dominated in connection with the transaction at issue and that the domination was the instrument of fraud or otherwise resulted in wrongful or inequitable consequences. In other jurisdictions, the plaintiff must show that the corporate form in and of itself operated to serve some fraud or injustice, distinct from the alleged wrongs of individual defendant. The wrongful or fraudulent conduct caused harm: A critical component of the doctrine is establishing that the domination of the corporation or LLC led to an inequity, fraud, malfeasance, or injustice against the party seeking to pierce the corporation’s veil. Abuse of the corporation or LLC is not enough. Nor is a simple breach of contract, without more. To establish this element, there must be a temporal relationship between the domination by the owner, shareholder or member and the wrong. Therefore, the party seeking to pierce the corporate veil must establish a causal connection between the abuse of the corporate form and the wrongful conduct for which relief is sought. How to Protect Against Veil Piercing: Let’s go back to the hypothetical that started this article. You formed an LLC on the advice of your family, friends and neighbors.  The company, ABC Co. LLC, sells clothing accessories. Unfortunately, when you started the business, you did not capitalize it with sufficient funds. After a few months in business, you started to do several things that blurred the lines between you and the business. For example, you closed the business’s bank account and opened one account for both you and the business. You also personally guaranteed loans from creditors (such as the bank), and agreed to pay the business’s debts from your own personal assets. Finally, you failed to make sure the world knew it was dealing with ABC Co. – you failed to conspicuously identify the company status on all business cards, letters, quotes, invoices, statements, directory listings, advertisements, and other forms of company communication. Recognizing that you might be exposing youself to liability, you go back to the lawyer who helped you incorporate the business for advice. During your meeting, your lawyer tells you to do the following to avoid trouble: hold annual meetings of directors and shareholders or members, keeping accurate, detailed minutes of important decisions that are made at the meetings; adopt company by-laws; maintain a separate bank account for the company; maintain separate books and records; refrain from commingling personal assets with those of the business; refrain from using corporate assets for personal use; adequately capitalize the company; refrain from personally guaranteeing payment of the corporation or LLC’s debts; make sure the world knows it is dealing with a corporation or LLC by conspicuously identifying the company status on all business communications; sign company documents in your representative capacity; and refrain from engaging in illegal, fraudulent, or reckless acts. EB Ink Technologies, LLC v. Lamocu Holdings, LLC: Recently, a New York trial court, applying Delaware law, had the opportunity to consider the foregoing principles.  On November 28, 2016, Justice Kornreich of the New York County Supreme Court, Commercial Division, issued a decision in EB Ink Technologies, LLC v. Lamocu Holdings , LLC , 2016 NY Slip Op. 32339(U), dismissing a veil piercing claim. Facts of the Case: The case arose from an option held by EB Ink Technologies, LLC. (“EB Ink”) to acquire 20% of the fully diluted stock of T-Ink, Inc. (“T-Ink”), which was secured by T-Ink stock held in escrow. The number of shares in escrow was subject to increase ( e.g. , in the event of further dilution); the escrow was supposed to be “topped up” to reflect the 20% of T-Ink’s stock. The top up obligation was a contractual obligation of Lamocu Holdings, LLC (“Lamocu”), a Delaware LLC, as special purpose vehicle (“SPV”). EB Ink had no written agreement with the Individual Defendants (T-Ink’s founders) obligating them to personally top up the escrow with their own shares. Between December 2007 and May 2008, EB Ink and T-Ink entered into a number of agreements, pursuant to which EB Ink (1) purchased approximately 3.1% of T-Ink’s common stock; (2) loaned $22 million to T-Ink with the right to convert the loan into approximately 17.1% of T-Ink’s common stock; and (3) obtained a warrant to purchase 22% of T-Ink’s common stock on a fully diluted basis. The top up obligation was the result of these transactions. In October 2009, the Individual Defendants formed Lamocu in order to execute seven contracts with EB Ink. The action concerned only one of those contracts: the Option Agreement. The Option Agreement provided EB Ink with the right to purchase 20% of T-Ink’s common stock on a fully diluted basis for $5 million. The option expires on October 31, 2019. At the time the Option Agreement was executed, Lamocu did not own any shares of T-Ink other than those it deposited with the escrow agent.  EB Ink alleged that “ t was understood and agreed among the and EB Ink that the would at all times provide Lamocu with sufficient shares to satisfy its obligations under the Option Agreement.” Slip op. at 2 (internal quotation omitted). This alleged oral agreement was not contained or referenced in any of the parties’ contracts. By letter agreement dated March 5, 2013 (the “Letter Agreement”), the parties agreed to amend the Option Agreement so that the amount of shares due upon EB Ink’s exercise of its option would be fixed. This amendment would, therefore, eliminate the perpetual possibility of the escrow needing to be topped off until the option’s expiration in 2019. In October 2013, one of the Individual Defendants requested that EB Ink exercise its amended option rights under the Letter Agreement to facilitate a transaction with a non-party, Pacific Capital Group (“PCG”) and another investor, who were prepared to invest more than $3 million in T-Ink. EB Ink refused, contending that the conditions of the Letter Agreement had not been satisfied. Between November 13 and December 6, 2013, the same Individual Defendant and EB Ink negotiated the number of additional shares that would be needed to top up the escrow at the time the amended option was executed. But, no agreement was ever reached. EB Ink claims that it learned that the proceeds from PCG were being used for a purpose prohibited by the Letter Agreement, namely, an acquisition of a German technology company (which also, allegedly, was done by T-Ink acquiring a further $3 million payment obligation). Shortly thereafter, according to EB Ink, it discovered other improper uses of the proceeds. For these reasons, EB Ink never exercised its amended option under the Letter Agreement, nor did it exercise its original option under the Option Agreement, which it claimed was still effective (and which, as noted, does not expire until October 31, 2019). In January 2014, the same Individual Defendant orally conceded that the conditions under the Letter Agreement were not satisfied. He also allegedly admitted that the Option Agreement was not disclosed to PCG because PCG would not have provided T-Ink with financing had it known about EB Ink’s option. It was at that time, that the Individual Defendants allegedly verbally acknowledged their personal liability to top up the escrow under the Option Agreement. The parties then attempted to negotiate another proposed amendment to EB Ink’s option rights, but no such agreement was reached. By letter dated October 14, 2015, EB Ink demanded that Lamocu top up the escrow as required by the Option Agreement. Lamocu refused to do so, and EB Ink terminated the Letter Agreement. The Motion to Dismiss and Ruling: EB Ink commenced the action on January 7, 2016 by filing a complaint with seven causes of action: (1) a declaratory judgment that Lamocu and the Individual Defendants have the obligation to top up the escrow under the Option Agreement; (2) specific performance of the top up obligation, asserted against Lamocu; (3) specific performance of the top up obligation, asserted against the Individual Defendants; (4) piercing Lamocu’s corporate veil to hold the Individual Defendants liable for Lamocu’s top up obligations; (5) fraudulent inducement of the Option Agreement, asserted against Lamocu, the Individual Defendants, and T-Ink; (6) injunctive relief prohibiting the Individual Defendants from selling their T-Ink shares and T-Ink from repurchasing its shares from the Individual Defendants; and (7) anticipatory breach of the escrow top up obligation, asserted against Lamocu and the Individual Defendants. On April 29, 2016, the defendants filed a motion to dismiss, which sought dismissal of all claims except the breach of contract claim asserted against Lamocu (the second cause of action). The court granted the defendants’ motion. In granting the motion, Justice Kornreich observed that EB Ink’s complaint principally relied on claims of veil piercing and alleged oral admissions by the Individual Defendants.  These issues, said Justice Kornreich, were the “core issue ” in the case.  As such, the court set out to answer “whether the Individual Defendants be held liable for Lamocu’s top up obligations.” Although not stated explicitly in the decision, the court found that EB Ink properly alleged domination by the Individual Defendants, stating: “The allegations in the complaint regarding domination, control, and inadequate capitalization, as set forth above, are insufficient to pierce the corporate veil of a closely held Delaware LLC.” Slip op. at 4. But, as the quote shows, those allegations were insufficient to state a claim. The reason being “the requisite fraud allegations not alleged. The only bad act alleged, Lamocu’s breach of its contractual obligations, cannot be used to satisfy the fraud prong.” Id . Under Delaware law, a valid veil piercing claim requires the plaintiff to plead that the company “controlled by defendants Sham entit designed to defraud investors and creditors . . .” EBG Holdings LLC v. Vredezicht’s Gravenhage 109 B.V. , 2008 WL 4057745, at *12 (Del Ch 2008) (“the requisite element of fraud under the alter ego theory must come from an inequitable use of the corporate form itself as a sham, and not from the underlying claim.”). Takeaway: EB Ink reinforces the point that domination of the corporation is not enough to pierce the corporate veil. A plaintiff must demonstrate the other elements of the doctrine – namely, a fraud and causation.  EB Ink was unable to allege either.  In fact, Justice Kornreich made a point of noting that this failure was “fundamental” to the dismissal of the claim: On an even more fundamental level, the claim that the Individual Defendants were intended to be held liable for Lamocu’s top up obligations is based on the entirely foreseeable assumption that Lamocu, an SPV, would not have the ability to top up the escrow because it did not own the shares needed to do so. Even if the court found EB Ink’s position to be sympathetic, equity is not a concern the court may consider when interpreting a contract or assessing the legitimacy of a Delaware corporation. The parties here are sophisticated and, therefore, the court must enforce their agreement, even if the court or one of the parties believes the agreement to be unwise. EB Ink admits that it knew that Lamocu did not own shares of T-Ink that could be used to top up the escrow. Obviously, entering into a contract with a judgment proof SPV that obligates the SPV to deliver shares, which it does not own nor has the means to acquire, is an extremely perilous risk. It is hard to imagine a more extreme undertaking of counterparty credit risk. Had the parties intended to obligate the Individual Defendants, instead of just Lamocu, to top up the escrow, they could have (and would have) expressly done so in one of their many agreements. They did not. The court cannot rewrite the parties’ contract to give EB Ink a better bargain than it negotiated. Rather, the court must give effect to the parties’ decision to not contract for the Individual Defendants to have the personal obligation to top up the escrow. Slip op. at 4 (citations and internal quotations omitted).

Previously, this Blog wrote about the importance of having a complete record when challenging an arbitration award.  Recently, two claimants in arbitration learned the hard way that an incomplete record will not support vacatur of an award.  See Abbott vs. RBC Dain Rauscher Inc. , No. 1-15-1612, 2016 IL App. (1st) 151612-U (Ill. App., 1Dist., 9/29/16). The Arbitration P roceeding: David James and Michael Abbott (“Plaintiffs”) filed a claim in arbitration against RBC Dain Rauscher Incorporated, now known as RBC Capital Markets Corporation, and Charles Lane, a broker at RBC Capital (“Defendants”), for violating various financial regulations. The Plaintiffs retained RBC Capital and Lane as their financial consultants. Around 2005, the Plaintiffs discovered unsuitable trades in their accounts. In September 2008, the Plaintiffs filed a five-count statement of claim before the Financial Industry Regulatory Authority (“FINRA”). The Plaintiffs asserted violations of the federal securities laws and Illinois consumer laws, and various claims under the common law. The matter went to arbitration for over two years with hearings spanning approximately 57 days. In February 2014, a three-member panel awarded the Plaintiffs almost $200,000 in compensatory damages and $3,000 in sanctions against the Defendants. During the hearing, the Plaintiffs orally moved to submit two FINRA news releases (from 2009 and 2010) and also a “financial industry regulatory letter of acceptance, waiver, and consent,” which is the equivalent of a FINRA settlement, involving RBC Capital. The hearing transcript revealed that counsel for the Plaintiffs briefly described the documents, outlined their contents, and argued they would buttress his expert’s testimony that the Defendants had violated various industry standards and that RBC failed to properly supervise its employees, including Lane. The presiding arbitrator held that the documents did not relate directly to the claims and denied their admission as exhibits. The presiding arbitrator nonetheless reserved the matter for the close of evidence. At the close of evidence, counsel for the Plaintiffs again moved to submit the documents as exhibits. The presiding arbitrator stated that the Plaintiffs could attach the documents to their closing brief and that essentially the arbitrators may or may not review them. The Plaintiffs, however, did not attach the documents. The Motion Court Proceedings: The Plaintiffs moved to vacate the arbitration award, arguing that the arbitrators refused to hear evidence material to the matter, thereby rendering their damages award insufficient. The court denied their motion, holding the matter was within the arbitrators’ discretion. The Plaintiffs filed a motion to reconsider, which was denied. The court thereafter granted the Defendants’ motion to confirm the arbitration award. The Plaintiffs appealed the judgment affirming the arbitration award, contending that the arbitrators did not properly consider the evidence described above. The Appellate Court Ruling: On appeal, the Plaintiffs challenged the motion court’s ruling denying their motion to vacate the arbitration award, arguing the arbitrators erred in declining to admit the news releases and settlement documents. The Plaintiffs maintained that had these documents been admitted, they would have been able to establish liability against RBC for the failure to monitor employee activities, and then been able to obtain punitive damages. The Plaintiffs contended that their expert should have been allowed to testify about the news releases and settlement documents, but inexplicably failed to provide the court with the full transcripts of their expert’s testimony, the Defendants’ expert’s testimony, or that of any other witness. Instead, they only provided the court with snippets of arbitration testimony and transcripts of their interchange with the court and opposing counsel, whereby they argued the evidence at issue should have been admitted. Incredibly, as the Court noted, “ ome of the snippets not even identify by name which witness is testifying.” Slip op. at n.2. The Court held that, even assuming the Plaintiffs had properly sought to admit the documents, “without a record bearing the full hearing testimony, especially that of the competing experts,” it could not say that those documents “were so material to the matter at hand that without them the course of the case would have changed vis a vis RBC.” Id . at 6. Consequently, the Court affirmed the judgment. Takeaway: The teaching of Abbott is simple: a party challenging an arbitral award must file as complete a record as possible to support the motion, taking care to highlight all evidence, not merely snippets and argument among counsel. The importance of this teaching cannot be underscored enough because the party seeking to vacate an arbitral award has the burden of establishing the basis upon which the award should be vacated. Unfortunately for the Plaintiffs in Abbott , they did not learn the lesson. They failed to meet their burden because they “submit a record … woefully insufficient to find prejudice or that plaintiffs were deprived of a fair arbitration hearing.” Slip op. at 7.

Jane is a shareholder in ABC Co. Over the past three years, the company has been losing money, due in large part to an increase in expenses. Jane learns the truth about the company’s financial condition and discovers that senior managers of the company are reporting their personal use of the company’s jet, cars and houses as a business expense. Because of managements’ failure to properly report the use of company property, the company’s expenses have skyrocketed. Jane wants to recover the expenses incurred because of the managers’ misuse of corporate property. Jane can do so by filing a shareholder derivative action. A derivative action is a lawsuit brought by a shareholder of a company, on behalf, and for the benefit, of the company to enforce or defend a legal right or claim. Derivative actions seek the recovery of damages and/or equitable relief arising from unlawful or improper conduct engaged in by officers, directors, or other persons in control of the company. Such conduct includes, but is not limited to: breaches of fiduciary duty; fraud; self-dealing by insiders; conflicts of interest; waste of company assets; insider trading; options backdating; inflated, false, or misleading financial statements; improprieties related to executive compensation; conduct leading to regulatory investigations; and management or board decisions that expose the company to harm or risk ( e.g. , violations of consumer protection laws, environmental violations). A derivative action allows current shareholders to bring an action in the name of the company to redress the harm caused by management where it is unlikely that management will redress the harm itself. In addition to the recovery of damages, which are awarded to the company and not to the individual shareholders that initiate the action, a successful derivative action may include corporate governance reforms that strengthen and protect shareholder value. Any recovery of money or implementation of governance reforms by way of settlement must be approved by the court. Approval must be based on facts and circumstances showing that the result is fair and reasonable to the company and in its best interest. Although a shareholder has the derivative action in his/her arsenal, he/she cannot immediately run to court to redress the alleged wrongdoing. The shareholder must first formally demand the company’s board of directors act in the manner that the shareholder requires, such as suing the wrongdoers. The “demand” requirement, however, can be waived if the suing shareholder can show that such a demand would have been futile. If the shareholder makes a demand on the board, then the board must be allowed time to determine the proper course of action to pursue. To assist it, the board will often seek outside counsel and/or create a committee of disinterested directors who were not involved in the transaction about which the shareholder is complaining. If the board and/or committee recommend legal action, then the board will likely file an action against the wrongdoers who have pursued, or are pursuing, the illegal or improper course of conduct. If, however, the board and/or the committee determine that legal action is not appropriate, then the demanding shareholder may commence an action on his/her own for the benefit of the company. In addition to the demand requirement, many jurisdictions require a shareholder to prove that he/she has standing to bring the action. These laws often require the shareholder to meet certain qualifications, such as maintain a minimum value of the shares held and the hold the shares for a certain period of time. Culligan Soft Water Company v. Clayton Dubilier & Rice, LLC As noted above, any settlement of a derivative action must be approved the court. See , e.g. , Section 626(d) of the New York Business Corporation Law. In June 2015, the Honorable Jeffrey K. Oing, Justice of the Supreme Court, New York County, approved such a settlement.  However, on November 29, 2016, the First Department reversed that approval because, among other reasons, the settlement did not confer a benefit on the company. Culligan Soft Water Co. v. Clayton Dubilier & Rice, LLC , 2016 NY Slip Op. 08021. The Motion Court Proceedings : On June 8, 2015, Justice Oing approved the partial settlement of a derivative action brought by minority shareholders of Culligan Soft Water Company (“Culligan”).  The action arose from the $610 million leveraged buyout (“LBO”) of the company by Clayton Dubilier & Rice, LLC (“CD&R”), a private equity firm.  The suing shareholders claimed that after CD&R bought Culligan, it saddled the company with more debt than it could repay. At the same time, CD&R extracted the company’s value for its own benefit through a series of transactions, including a $375 million dividend, and allowed its debt to be sold at a steep discount to investment firms Angelo Gordon & Co., Silver Oak Capital LLC and Centerbridge Partners LP (the “Lenders”). The shareholder plaintiffs reached a settlement with Angelo Gordon, Centerbridge and a related entity.  Under the settlement, the Lenders agreed to pay the shareholders $4 million to be held in trust and used to settle the plaintiffs’ past legal fees, as well as fund the derivative action against CD&R and the current and former Culligan officers and directors. CD&R and the director defendants objected to the proposed settlement, arguing, among other things, that the proposed settlement only benefited the plaintiffs – the minority shareholders – and not the company or its two largest shareholders, both CD&R entities. At oral argument, Justice Oing rejected these arguments, though he expressed skepticism at first, questioning whether it would be better to keep the $4 million in escrow, pending the final resolution of the case.  Justice Oing found that the partial settlement was fair since it resolved the claims against the Lenders (which related to the restructuring and the acquisition of Culligan’s assets pursuant to a 2012 exchange transaction) and provided money for the claims against the remaining defendants, in addition to cooperation from the Lenders in the continued litigation. Justice Oing noted that the proposed partial settlement “compartmentalized” the suit by removing peripheral claims, while keeping the focus on the central allegations of the action – those concerning the LBO and the allegedly illegal distributions paid to CD&R and the Culligan officers and directors. In his bench ruling, Justice Oing underscored the fact that, under the settlement, the minority shareholders would receive $4 million and cooperation from the Lenders to pursue the larger case, which was in the best interest of the broader case: “Those are factors they had to weigh and think about, not only for their benefit but also for the company’s benefit, and at the end of the day, that is something I cannot ignore.” The First Department’s Holding: On November 6, 2016, the First Department heard argument on CD&R’s objections to the partial settlement. As an initial matter, CD&R argued that the plaintiffs, minority holders of beneficial shares of the company, did not have standing to settle the claims. CD&R noted that the plaintiffs were Culligan franchisees and “business partners” with the defendant investment firms that bought Culligan’s debt after CD&R’s $610 million LBO. Additionally, CD&R argued that the settlement provided no benefit to Culligan. According to CD&R, the settlement benefited the minority shareholders and not the corporation. “The money is going straight into the pockets of the dealers, their trade association and its attorneys,” said CD&R’s counsel. “ hey haven’t obtained anything except cash for their trade association.” Notably, the minority shareholders did not disagree, stating: “The $4 million is to be used for legal fees and to the extent that there’s anything left, it would go to the company.” Neither the trade association nor the dealers would receive any money outside of what they had spent on legal fees. Approximately three weeks later, the First Department agreed with CD&R and the company defendants and reversed the approval of the partial settlement. In a unanimous, terse opinion, the Court accepted the reasons advanced by these defendants for vacating the judgment below: The settlement does not provide for payment to the company. Plaintiffs are to receive the bulk of the $4 million settlement in reimbursement for their legal fees in this case, and the remainder is to be turned over to their franchisee organization for future legal fees or for distribution, at the organization's discretion, to plaintiffs. Moreover, because they have not obtained a substantial benefit for the company, but have accomplished only getting their lawyers paid, plaintiffs, who, after four attempts, have yet to plead properly that they have standing to sue derivatively, are not entitled to legal fees. It was an abuse of discretion to approve the settlement of a derivative action purporting to bind the company and all shareholders that was obtained by plaintiffs who had not established — and may never establish — their standing to bring the action. Contrary to plaintiffs' argument, defendants, as shareholders in the company who received notice of the settlement and had an opportunity to and did object to the settlement, have standing. Internal citations omitted. Takeaway: It is well-established that the fundamental purpose of a derivative action is to vindicate a wrong done to the company. Because that is the purpose of the derivative action, New York courts have long held that any recovery obtained in a derivative action should be for the benefit of the injured company. Thus, any monetary payment recovered and/or non-monetary benefit obtained in the action must be paid and/or flow to the company whose claims are at issue. The settlement before the Court in Culligan , however, did not comport with these principles. The record showed that in exchange for a broad release of Culligan’s claims against the settling parties, the minority plaintiffs would receive: (1) $4 million to be paid directly to their franchise dealers association, which was given complete discretion –without court review– to distribute attorney’s fees, hold “up to $1 million” in trust “to fund future legal expenses,” and to pay the balance “directly to Plaintiffs” in proportion to their fundraising efforts for the association; and (2) cooperation in the continued litigation ( i.e. , the ability to subpoena documents and testimony from the settling parties) – consideration that was opposed by the company and its majority shareholder because it only conferred a benefit on the plaintiffs and their attorneys. The Court rightly found that neither form of consideration provided any benefit to Culligan or its majority shareholder. Where derivative actions are concerned, courts must be vigilant in protecting the interests of the corporation and shareholders, especially in the context of settlement. The reason courts are given such a responsibility is “to discourage the private settlement of a derivative claim under which a shareholder-plaintiff and his attorney personally profit to the exclusion of the corporation and the other shareholders....”  Mokhiber on Behalf of Ford Motor Co. v. Cohn , 783 F.2d 26, 27 (2d Cir. 1986). By examining the substance of the proposed settlement in Culligan , the Court fulfilled its role as gatekeeper and ensured that the relief obtained was fair and reasonable and would go to the company. As the Court found, however, the partial settlement did not provide a real or substantial benefit to the company but, instead, allowed the plaintiffs to negotiate fees in exchange for illusory benefits to the corporation and broad general releases for the alleged wrongdoers.

In an article entitled “Why You Won’t Get Your Day in Court” appearing in The New York Review of Books, Judge Jed S. Rakoff of the United States District Court for the Southern District of New York, tried to explain why this is so. According to Judge Rakoff, there are several reasons for this occurrence. These include: the “cost of hiring a lawyer”; “the increased expense, apart from legal fees, that a litigant must pay to pursue a lawsuit to conclusion”; the “increased unwillingness of lawyers to take a case on a contingent-fee basis when the anticipated monetary award is modest”; “the decline of unions and other institutions that provide their members with free legal representation”; “the imposition of mandatory arbitration”; “judicial hostility to class action suits”; “the increasing diversion of legal disputes to regulatory agencies”; and “in criminal cases, … the … increased risk of a heavy penalty in going to trial.” Judge Rakoff observed that there are a number of “disturbing trends” that illustrate the consequences of these factors. For example, “as many as two thirds of all individual civil litigants in state trial courts are representing themselves, without a lawyer,” including “people of moderate means” who “cannot afford a lawyer.” As Judge Rakoff noted, this trend has had a negative impact on such litigants because “ nividuals not represented by lawyers lose cases at a considerably higher rate than similar individuals who are represented by counsel, … even when the judge tries to compensate for counsel’s absence.” The inability to afford a lawyer goes beyond simply affording attorney’s fees. It goes to the costs of litigation, which have “proved to be excessively expensive.” As Judge Rakoff observed, these costs “not only place[] impecunious parties at a disadvantage but, again, also discourage[] ordinary people from bringing meritorious lawsuits in the first place.” Even the contingent-fee arrangement does not adequately cure the problem, according to Judge Rakoff. For starters, “contingent-fee arrangements only benefit those … who are suing rather than being sued.” Under most state rules of professional responsibility, the plaintiff who has a contingent-fee arrangement “is still personally responsible for paying for the costs of the lawsuit,” which “frequently amount to thousands of dollars.” “Most importantly,” said Judge Rakoff, “the time-consuming nature of modern litigation means that most contingent-fee lawyers will simply refuse to take on a case that does not promise an award or settlement of at least several hundred thousand dollars, leaving those tort victims who cannot sue for large amounts unable to have a day in court.” If the fees and expenses don’t impede access to the courts, then “one-sided contracts” requiring arbitration will, said Judge Rakoff. These agreements, drafted by counsel for employers and the seller of goods and services, require disputes to be decided in arbitration rather than in court. Even though these agreements are rightly called “contracts of adhesion”, “ i.e. , one-sided contracts imposed on weaker parties who have no realistic ability to negotiate, let alone contest the terms,” they nevertheless have been upheld and enforced by the courts, including the United States Supreme Court. So, What is the Solution? Judge Rakoff offered a few suggestions to open the courthouse doors to ordinary Americans.  These solutions, which Judge Rakoff believes will not “come easily”, include legislative responses, “state-sponsored legal insurance”, “a guarantee of counsel to indigent civil litigants” and a “lawyer-subsidized provision of cheaper legal services.” Perhaps the most immediate solutions, said Judge Rakoff, should come from the courts: But while the larger solutions to this denial of access must await a change in the legislative climate, there is, I am convinced, no reason short of ignorance or ideology for judges to continue to give their approval to devices that effectively deny Americans access to their courts…. And lower court judges, state and federal, could take a harder look at some of the practices described here that have the same effect. This would require a considerable change of thought on the part of many judges. Indeed, it is hardly surprising that judges who often have substantial dockets tend to look favorably on arrangements that will lessen their work burden, whether by mandatory arbitration, denial of jurisdiction, reliance on prosecutors and administrators, or similar measures. Too often, however, such relief morphs into an effective reduction of judicial responsibility, with dire consequences for the long-term ability of the courts to serve as an effective check on the power of the legislature and the executive. Arguably even worse, the situation I’ve described reinforces the belief of citizens that the courts are not an institution to which they can turn for justice, but are simply a remote and expensive luxury reserved for the rich and powerful. If the judges themselves do not take steps to counter this insidious trend, who will? This Blog’s Takeaway: Judge Rakoff makes several strong points, especially with regard to the costs of litigation. For this reason, Freiberger Haber LLP (the “Firm”) has been dedicated to making litigation and consultation services efficient and affordable.  The Firm understands that clients are concerned about cost certainty.  Therefore, the Firm uses flexible fee arrangements to deliver value to its clients for all types of legal matters, from the routine to the complex. At Freiberger Haber LLP, we work with our clients to develop risk-sharing solutions and alternative fee arrangements to help them address their business and litigation challenges. Whether through hourly fees, fixed fees, collared fees, contingent fees, success fees/holdbacks, or any combination of approaches, the Firm crafts fee arrangements that reduce overall costs, improve predictability, share risks and align incentives. In this way, the Firm can provide the best value and result to its clients.