Second Circuit Clarifies “Substantial Assistance” Standard for Aiding and Abetting Liability in SEC Enforcement Actions: Section 20(e) of the Securities Exchange Act of 1934 allows the SEC, but not private litigants, to bring civil actions against aiders and abettors of securities fraud. Under this section, the SEC may bring an enforcement action against “any person that knowingly provides substantial assistance” to a primary violator of the securities laws. On August 8, 2012, in SEC. v. Apuzzo, 689 F.3d 204 (2d Cir. 2012), the Second Circuit lowered the bar necessary to state a claim for aiding and abetting. Noting that prior case law may have been unclear, the Second Circuit rejected the argument that the SEC is required to plead or prove that an aider and abettor proximately caused the primary securities law violation. Instead, relying on a 75-year-old decision by Judge Learned Hand, the Court stated that once the government proves that a primary violation occurred and that the defendant had knowledge of it, the government need only prove that the defendant associated himself with the fraudulent scheme and sought to make it succeed. This relaxed standard will make it easier for the SEC to pursue enforcement actions against individuals who assist others in committing securities violations.
Joseph Apuzzo was the Chief Financial Officer of Terex Corporation, a manufacturer of mining equipment. The government alleged that, with Apuzzo’s assistance, United Rentals, Inc., one of the largest equipment rental companies in the world, and its Chief Financial Officer, Michael Nolan, carried out two fraudulent sales-leaseback transactions designed to allow United Rentals to recognize revenue prematurely and inflate the profit generated from sales. As part of this scheme, United Rentals sold used equipment to General Electric Credit Corporation (“GECC”) and leased the property back for a short period of time. In order to secure GECC’s participation in the sales-leaseback, United Rentals convinced Terex to agree to resell the equipment for GECC at the end of the lease period and to guarantee that GECC would receive no less than 96% of the purchase price that GECC paid United Rentals to acquire the equipment. To obtain Terex’s agreement, United Rentals secretly promised to indemnify Terex for any losses that Terex sustained and to make substantial equipment purchases from Terex in the future. Pursuant to Generally Accepted Accounting Principles, United Rentals could immediately recognize the revenue generated by the sale of equipment to GECC if it could demonstrate, among other things, that the risks and rewards of ownership had been fully transferred to GECC. However, because it had secretly agreed to indemnify Terex for any losses that Terex incurred, that requirement was not met, and therefore United Rentals could not properly record the revenue from the sales. The government alleged that Apuzzo knew that if the indemnification payments were disclosed, United Rentals would not be able to recognize the revenue. The government also claimed that Apuzzo executed various agreements and approved false invoices to conceal the indemnification payments.
For a defendant to be liable as an aider and abettor in a civil enforcement action, the SEC must prove: “(1) the existence of a securities law violation by the primary (as opposed to the aiding and abetting) party; (2) ‘knowledge’ of this violation on the part of the aider and abettor; and (3) ‘substantial assistance’ by the aider and abettor in the achievement of the primary violation.” SEC v. DiBella, 587 F.3d 553, 566 (2d Cir. 2009) (quoting Bloor v. Carro, Spanbock, Londin, Rodman & Fass, 754 F.2d 57, 62 (2d Cir. 1985)). Relying on Bloor, the District Court found that although the complaint plausibly alleged that Apuzzo had actual knowledge of the primary violation, it did not adequately allege “substantial assistance” because the government did not allege that Apuzzo proximately caused the harm on which the primary violation was predicated. Specifically, the Court held that “the complaint contains factual allegations which taken as true support a conclusion that there was a ‘but for’ causal relationship between Apuzzo’s conduct and the primary violation, but do not support a conclusion that Apuzzo’s conduct proximately caused the primary violation.” SEC v. Apuzzo, 758 F. Supp. 2d 136, 148 (D. Conn 2010). Concluding that proximate causation was required to satisfy the “substantial assistance” component of aider and abettor liability, the District Court granted Apuzzo’s motion to dismiss.
The Second Circuit reversed and clarified the standard for determining the substantial assistance prong for aider and abettor liability. Relying on criminal case law for guidance, the Court reasoned that the conduct of an aider and abettor that was sufficient to impose criminal liability would also be sufficient to impose civil liability in an enforcement action. The Court then noted that in Peoni, Judge Hand set forth the classic formula for aider and abettor liability in criminal cases by stating that the government—in addition to proving that the primary violation occurred and that the defendant had knowledge of it—must prove “that he in some sort associate[d] himself with the venture, that [the defendant] participate[d] in it as in something that he wishe[d] to bring about, [and] that he [sought] by his action to make it succeed.” Apuzzo, 689 F.3d at 206. (quoting Peoni, 100 F.2d at 402.)
The Second Circuit concluded that this was likely the clearest definition possible and then rejected Apuzzo’s argument that substantial assistance should, instead, be defined as proximate cause. The Court determined that that argument ignored the difference between an SEC enforcement action and a private suit for damages. “Proximate cause” is the language of private tort actions; it derives from the need of a private plaintiff, seeking compensation, to show that his injury was proximately caused by the defendants’ actions. But, in an enforcement action, civil or criminal, there is no requirement that the government prove injury, because the purpose of such actions is deterrence, not compensation. Id. at 213.
Applying this new standard, the Second Circuit concluded that the complaint alleged that Apuzzo provided substantial assistance in carrying out the fraud because he negotiated the details of both transactions, extracted agreements for Terex, and signed inflated invoices to further the fraud. The Court thus reversed the District Court’s order and remanded the case for trial.
Because only the SEC may bring civil claims for aiding and abetting securities law violations, this decision will not affect private litigants. However, it will likely increase the number of enforcement actions brought against individuals who assist others in transactions designed to make financial statements seem more attractive. The SEC has long relied on theories of secondary liability to enforce the federal securities laws. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which confirmed that knowing or reckless behavior can form the basis for liability for securities fraud. The Second Circuit’s decision in Apuzzo continues this recent trend in easing the SEC’s burden in secondary liability cases.
NLRB Prohibits Employers from Requesting that Employees Keep Silent About Internal Investigations: The National Labor Relations Board (the “Board”) recently issued a surprising decision that has important ramifications for internal investigations conducted by employers. In Banner Health System d/b/a Banner Estrella Medical Center, 358 N.L.R.B. No. 93 (July 30, 2012), the Board found unlawful the common practice by employers of requesting that an employee witness in an investigation not discuss the matter with other employees pending the completion of the investigation. Although the verbal instruction—which the employer provided to all employees involved in an investigation—was not accompanied by any threat of disciplinary consequences for its violation, the Board held that the request constituted an impermissible restraint on employees’ right to engage in protected concerted action under Section 7 of the National Labor Relations Act. As such, the Board issued an order requiring the employer to cease and desist from “[m]aintaining or enforcing the rule that employees may not discuss with each other ongoing investigations of employee misconduct” and to post a notice stating the same. Banner Health System, 358 NLRB No. 93 (Slip Opinion at 3).
The underlying investigation involved an employee who alleged that his negative performance review was in retaliation for his refusal to follow his supervisor’s improper instructions. In interviewing the employee, a human resources manager utilized a standard interview form wherein the employee was given the following verbal instruction:
This is a confidential interview and I will keep our discussion confidential except as required by law, or [Company] policy or as necessary to conduct this investigation. I ask you not to discuss this with your coworkers while the investigation is going on, for this reason: when people are talking it is difficult to do a fair investigation and separate facts from rumor.
A copy of the form was not provided to the employee.
For reasons apart from this instruction and not relevant to this note, the employee subsequently filed a claim with the NLRB alleging that Banner Health System committed certain violations of Section 8(a)(1) of the National Labor Relations Act, which prohibits employers from interfering, restraining, or coercing employees’ enjoyment of their Section 7 rights. The Board issued a complaint and notice which was subsequently amended to address the verbal confidentiality instruction.
Following a hearing on the complaint, the Administrative Law Judge upheld the verbal confidentiality instruction, finding that the employer had a “legitimate business reason for making this suggestion.” Id. at 6 (emphasis added). Specifically, the hearing judge recognized that the purpose of the “suggestion” was “to protect the integrity of the investigation.” Id.
On appeal, the Board reversed in a 2-1 decision. The Board found that the employer’s “blanket” (rather than case-by-case) approach of instructing all employee witnesses in an investigation to maintain confidentiality was an impermissible restraint on the employees’ Section 7 rights. The Board explained that an employer’s “generalized concern with protecting the integrity of its investigations is insufficient to outweigh employees’ Section 7 rights” to engage in concerted action for mutual aid and protection. Id. at 2.
Moreover, it was of no consequence to the Board that the instruction was merely a request. Nor did it matter that the request was not accompanied by an express threat of discipline for violation of the request. In the Board’s view, “[h]owever characterized, [the instruction], viewed in context, had a reasonable tendency to coerce employees, and so constituted an unlawful restraint....” Id.
In reaching this decision, the Board announced that, for a confidentiality instruction to be valid, an employer must first assess whether the instruction is necessary given the circumstances of the specific situation. In making that determination, the employer should consider the following non-exhaustive factors:
(1) “[W]hether in any give[n] investigation witnesses need protection”;
(2) Whether “evidence [is] in danger of being destroyed”;
(3) Whether “testimony [is] in danger of being fabricated”;
(4) Whether “there [is] a need to prevent a cover up.”
Employers conducting internal investigations of complaints and alleged misconduct have routinely issued confidentiality instructions for purposes of preserving the integrity of the investigation. Pursuant to this ruling—which applies to both union and non-union workplaces—such confidentiality instructions violate Section 8(a)(1) unless the instruction is narrowly tailored to the specific situation.
A strict interpretation of the Board’s decision would prove difficult to implement. Oftentimes, an understanding of the facts necessary to fully contemplate the considerations listed by the Board is impossible without at least some investigation. By the time that sufficient facts have been gathered to support a confidentiality instruction, the investigation may have already been tainted by behavior that would have been prevented by the earlier issuance of an instruction. The Board, however, would have no reason to promulgate an unworkable rule. This suggests that the Board, though uncomfortable with blanket confidentiality restrictions, views instructions appropriate so long as grounded in a reasonable basis that is specific to the matter under investigation. In other words, employers should utilize confidentiality instructions only after identifying specific concerns that make such an instruction appropriate.
With this understanding in mind, employers should revisit their internal policies and procedures governing (and agreements applicable to) internal investigations. Policies and procedures should be updated if necessary to implement a formal company policy regarding the issuance of confidentiality instructions. The policy should specifically address each of the four considerations identified above and require the individual undertaking the investigation to specifically list the facts at issue that justify the instruction prior to issuing the instruction. This record should be maintained in the event of subsequent litigation.