The Journal of The DuPage County Bar Association

Back Issues > Vol. 9 (1997)

Adverse Inferences and Preclusion Orders in S.E.C. Civil Securities Fraud Litigation
By Scott B. Hamilton

Author’s Note: The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the Staff of the Commission.

During investigations and civil securities fraud litigation brought by the Securities and Exchange Commission ("SEC" or "Commission"), defendants are frequently compelled to give testimony under oath and to provide the Commission with other discovery. Technically there are no defendants or targets in Commission investigations. Commission investigations are strictly fact-finding processes used to determine whether there have been any violations of the federal securities laws. In addition, in Commission administrative proceedings, the individuals and entities sued are called respondents. However, for purposes of this article, the author uses the term "defendants" broadly to include individuals and entities asked to testify and produce documents in Commission investigations, respondents in administrative actions, and defendants in civil and criminal enforcement proceedings. Because of the possibility that such testimony or discovery might tend to incriminate them in subsequent or parallel criminal proceedings, The government may pursue related civil and criminal actions arising out of the same set of operative facts, either simultaneously or successively. SEC v. Dresser Industries, Inc., 628 F.2d 1368, 1374-75 (D.C. Cir.)(en banc)(citing Standard Sanitary Manufacturing Co. v. United States, 226 U.S. 20, 52 (1912) & United States v. Kordel, 397 U.S. 1 (1980)), cert. denied, 449 U.S. 993 (1980); SEC v. Grossman, 121 F.R.D. 207, 209 (S.D.N.Y. 1987); SEC v. Musella, Fed. Sec. L. Rep. (CCH) Para. 99156, 38 Fed. R. Serv. 2d 426 (S.D.N.Y. 1983) defendants often assert their Fifth Amendment privilege against self-incrimination and refuse to testify or to produce discovery. The Fifth Amendment provides that "no person ... shall be compelled in any criminal case to be a witness against himself... ." U.S. Const. amend V. The privilege is not limited to the criminal context; it can protect individuals from being compelled "‘to answer official questions put to him in any other proceeding, civil or criminal, formal or informal, where the answers might incriminate him in future criminal proceedings.’" Baxter v. Palmigiano, 425 U.S. 308, 316 (1976)(quoting Lefkowitz v. Turley, 414 U.S. 70, 77, (1973)); LaSalle Bank Lake View v. Seguban, 54 F.3d 387, 389 (7th Cir. 1995). In many situations, the practical effect of such invocation is to frustrate the SEC’s investigation or litigation, because the Commission is unable to obtain information from the person with the most knowledge of the events in question. One district court described the problem by stating "it would seem proper to afford a civil litigant stymied by his adversary’s silence some means of moderating the potentially overwhelming disadvantage he faces in establishing his case." SEC v. Musella, 578 F. Supp. 425, 429 (S.D.N.Y. 1984). The Musella court recognized that a defense strategy which includes invoking the privilege "clearly cripples plaintiff’s efforts to conduct meaningful discovery and to marshal proof in an expeditious fashion, if at all." Musella, 578 F. Supp. at 429. In certain types of cases, such as insider trading, "where the nature of the violation makes the proof inherently difficult to obtain, assertion of the privilege may lead to a complete failure of proof." Id. Moreover, some litigants invoke the privilege to abuse, manipulate or gain an unfair strategic advantage over opposing parties. See e.g., United States v. Certain Real Property and Premises Known As 4003-4005 5th Ave., Brooklyn, NY, 55 F.3d 78, 84 (2d Cir. 1995) (since an assertion of the Fifth Amendment is an effective way to hinder discovery and provides a convenient method for obstructing a proceeding, trial courts must be especially alert to the danger that the litigant might have invoked the privilege primarily to abuse, manipulate or gain an unfair strategic advantage over opposing parties); SEC v. Graystone Nash, Inc., 25 F.3d 187, 190 (3d Cir. 1994)(discussing the potential for abuse and exploitation by the party invoking the privilege). In these situations, the Commission is not helpless.

If thwarted in an investigation or civil proceeding by the Fifth Amendment privilege, the Commission can seek from the defendant’s silence an adverse inference as to the facts upon which the person refuses to testify. Should a defendant later try to achieve an unfair strategic advantage by first invoking and then waiving the privilege, or presenting other evidence in his defense, the Commission can move for preclusion orders barring the defendant from presenting such evidence at trial.

This article will begin with a brief chronology of a Commission investigation and subsequent civil enforcement proceedings to describe the potential occasions when a defendant might choose to assert his Fifth Amendment privilege. The article will then discuss how the Commission has used adverse inferences and preclusion orders to counteract the tactical advantage defendants gain from invoking the Fifth Amendment privilege. Finally, this article will discuss how courts often reject defendants’ efforts to stay civil proceedings to avoid the adverse impact of Fifth Amendment silence.

II. Overview of Civil Securities Fraud Investigations and Litigation

A. Informal or Preliminary Investigations

Commission investigations often begin as informal or preliminary investigations. Guidelines for Commission informal investigations are found at 17 C.F.R. Sec. 202.5. During informal investigations, the Commission’s Staff generally relies on the voluntary cooperation of the individuals being investigated to provide it with documents and administrative testimony under oath, because the Staff does not have the power to subpoena testimony or documents. Given the informal nature of preliminary investigations, it is rare that issues regarding the Fifth Amendment arise at this stage. Since the Commission cannot compel either a witnesses’ testimony or the production of documents, most witnesses, if asked to disclose incriminating information, may simply refuse to cooperate instead of invoking the privilege. Yet, on occasion, witnesses have invoked their Fifth Amendment privilege during voluntary administrative testimony.

B. Formal Investigations

If the Staff believes it is necessary to compel testimony and production of documents to complete its investigation, it will then seek Commission authorization to begin a formal investigation. See, e.g., Sections 19(b) and 20(a) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. Secs. 77s(b) & 77t(a), Sections 21(a) & (b) of the Exchange Act ("Exchange Act"), 15 U.S.C. Secs. 78u(a) & (b), Sections 209(a) & (b) of the Investment Advisers Act of 1940 ("Advisers Act"), 15 U.S.C. Sec. 80b-9(a) & (b), and Sections 42(a) & (b) of the Investment Company Act of 1940 ("Investment Company Act"), 15 U.S.C. Secs. 80a-41(a) & (b). During a formal investigation, the Commission can empower Staff members with broad investigative authority including the power to administer oaths, subpoena witnesses, take evidence and require the production of documents. Quite frequently during formal investigations, witnesses will assert their Fifth Amendment privilege in the course of administrative testimony or in response to Commission subpoenas seeking the production of documents.

C. Litigation

If the Staff discovers during its investigation that a person has engaged or is about to engage in acts or practices which constitute violations of the securities laws, the Staff generally seeks Commission authorization to institute one of the following enforcement actions: cease and desist proceedings, administrative actions, civil injunctive actions, and criminal actions by way of referral to the Department of Justice. The most frequently cited statutory authority for these actions and for criminal referrals are as follows: cease and desist proceedings — Section 8A of the Securities Act, 15 U.S.C. Sec. 77h-1, Section 21C of the Exchange Act, 15 U.S.C. Sec. 78u-3, and Section 203(k) of the Investment Advisers Act, 15 U.S.C. Sec. 80b-3(k); administrative actions — Section 15(b) of the Exchange Act, 15 U.S.C. Sec. 78o(b), and Section 203(e) of the Investment Advisers Act, 15 U.S.C. Sec. 80b-3(e); civil actions and criminal referrals — Section 20(b) of the Securities Act, 15 U.S.C. Sec. 77t(b), Section 21(d) of the Exchange Act, 15 U.S.C. Sec. 78u(d), Section 209(d) of the Investment Advisers Act, 15 U.S.C. Sec. 80b-9(d); Section 42(d) of the Investment Company Act, 15 U.S.C. Sec. 80a-41(d). Depending upon the status of the defendant, the Commission will often institute multiple enforcement proceedings, because the statutory authority for enforcement actions does not necessarily provide complete relief against certain defendants in one forum. For example, if the defendant is a registered representative, Registered representative is the term of art for people more commonly known as stockbrokers. Because stockbrokers are associated with broker-dealers, they are subject to Section 15 of the Exchange Act and therefore can be the subject of administrative proceedings under that act. Section 15(b)(6) of the Exchange Act the Commission will not be able to permanently enjoin him from further securities fraud and bar him from the securities industry in one forum. In this situation, the Commission might first seek a permanent injunction in federal district court, to enjoin the representative from committing further securities fraud, and then seek administrative sanctions, such as a bar from the securities industry, in an administrative action. The range of potential sanctions for a registered representative in an administrative action include "censure, placing of limitations, suspension not exceeding 12 months, or bar" from the securities industry. Section 15(b)(6) of the Exchange Act. In egregious cases, the Commission might refer the matter to the Department of Justice for a criminal enforcement action. Section 21(d) of the Exchange Act authorizes the SEC to "transmit such evidence as may be available concerning such acts or practices [of potential securities laws violations] to the Attorney General, who may, in his discretion, institute necessary criminal proceedings under this title." Similar referral provisions are included in the Securities, Investment Advisers and Investment Company Acts.

After informal and formal investigations, a defendant might invoke his Fifth Amendment privilege on four more occasions: (1) during a deposition or other discovery in the injunctive action pursuant to Rule 26 of the Federal Rules of Civil Procedure, (2) during the injunctive hearing or trial, (3) during the administrative hearing, and (4) during the criminal trial.

By use of the Fifth Amendment privilege against self-incrimination, defendants often have control over the timing and the scope of their testimony throughout investigations and the civil enforcement process. However, when a defendant invokes the privilege, and thus impedes the Commission’s investigation or civil litigation, the Commission can attempt to neutralize any tactical advantage gained by seeking adverse inferences against that defendant.

III. Adverse Inferences

Courts in civil litigation may draw adverse inferences against witnesses who assert their Fifth Amendment privilege. Baxter v. Palmigiano, 425 U.S. 308, 318 (1976); LaSalle Bank Lake View v. Seguban, 54 F.3d 387, 389-390 (7th Cir. 1995). The Baxter Court adopted the prevailing rule that "the Fifth Amendment does not forbid adverse inferences against parties to civil actions when they refuse to testify in response to probative evidence offered against them... ." Baxter, 425 U.S. at 318. This rule has been widely recognized by circuit courts since the Baxter decision. LaSalle Bank Lake View, 54 F.3d at 390 (citing cases from the Second, Third, Fifth, Seventh and Eighth Circuits).

The Commission often uses adverse inferences in its enforcement actions. An example from the Seventh Circuit is SEC v. Cherif, 933 F.2d 403, 417 (7th Cir. 1991), cert. denied, 502 U.S. 1071 (1992). Cherif misappropriated confidential information from a past employer, First Chicago Bank, concerning financing for upcoming takeovers in order to engage in insider trading of the target companies’ securities. Cherif conducted his scheme by stealing confidential information from the bank’s files about the bank’s financing for the upcoming takeovers. Cherif conducted his scheme after his employment with the bank ended. Cherif gained entry into the bank at nights and on weekends by using his old keycard which he had fraudulently arranged to remain active. Unknown to Cherif, the bank’s security system automatically made a record of all his entries while using his keycard, and this evidence was used against him at the preliminary injunction hearing. Cherif, 933 F.2d at 407.

After obtaining a temporary restraining order, the Commission took Cherif’s deposition in preparation for the preliminary injunction hearing. During his deposition, Cherif asserted his Fifth Amendment privilege and refused to answer the Commission’s questions. Cherif, 933 F.2d at 407.

At the preliminary injunction hearing, the district court found that the Commission made a prima facie showing that Cherif had committed securities fraud based on the Commission’s evidence, which consisted of Cherif’s trading records, the record of Cherif’s entries into First Chicago, and the transcript of a taped conversation between Cherif and an informant where Cherif admitted to using his keycard to enter the First Chicago building. Id. In addition to this evidence, the district court relied upon the adverse inference which was created from Cherif’s silence in the face of this evidence. Id. Also presented at the hearing was the transcript from the informant’s plea agreement in which the informant recounted how Cherif had admitted reviewing documents in the bank’s finance department.

On appeal, the Seventh Circuit rejected Cherif’s challenge to the evidence presented against him. The Seventh Circuit noted that the "district court permissibly drew inferences from Cherif’s refusal to respond to probative evidence in this civil proceeding, [citing Baxter] and found that the SEC had presented evidence establishing that violations of the securities laws had occurred." Cherif, 933 F.2d at 412.

Courts in other Commission cases have likewise allowed the use of adverse inferences as evidence of securities fraud. SEC v. Scott, 565 F. Supp. 1513, 1533-34 (S.D.N.Y. 1983), aff’d, 734 F.2d 118 (2d Cir. 1984)(adverse inference added further support for conclusion that defendant violated the securities laws by his knowing failure to make necessary disclosures); SEC v. Musella, 578 F. Supp. 425, 429-30 (S.D.N.Y. 1984)(courts can draw an adverse inference in determining the sufficiency of SEC’s showing on an application for preliminary injunctive relief).

IV. Preclusion Orders

Some defendants who have sought shelter behind the Fifth Amendment emerge later to attempt to formulate a defense using the evidence withheld from the Commission during discovery. In these situations, the Commission and other government plaintiffs frequently seek preclusion orders barring defendants from offering any evidence related to the topics about which they asserted the privilege. If courts find that defendants have invoked the privilege to gain a strategic advantage, courts readily grant preclusion orders.

For example, in United States v. Certain Real Property and Premises Known as 4003-4005 5th Ave., Brooklyn, NY, 55 F.3d 78 (2d Cir. 1995), the defendant invoked his Fifth Amendment privilege and refused to answer interrogatories in a civil forfeiture proceeding. After the government moved for summary judgment, the defendant tried to waive the privilege so he could respond to the motion by submitting affidavits containing material previously asserted to be within his privilege. The district court found this tactic to be abusive and manipulative, and therefore barred the defendant from filing affidavits in opposition to the motion. Id. at 81.

On appeal, the Second Circuit noted that so long as the trial court attempted to accommodate both the defendant’s "valid Fifth Amendment interests and the opposing parties’ needs in having the litigation conducted fairly, we will not disturb the measures used by that court in the exercise of its discretion." 4003-4005 5th Ave., Brooklyn, NY, 55 F.3d at 85. In affirming, the Second Circuit found that the district court had not abused its discretion in ruling that the defendant was barred from submitting into evidence material previously claimed by him to be within the privilege. Id.

Another example is found in SEC v. Cymaticolor Corp., 106 F.R.D. 545 (S.D.N.Y. 1985). In Cymaticolor, the SEC brought an enforcement action against Joel Green and other defendants alleging that they had manipulated the price of Cymaticolor Corporation stock. Cymaticolor, 106 F.R.D. at 546. During discovery, Green refused to respond to interrogatories on the basis of his Fifth Amendment privilege. In response to this assertion of the privilege, the SEC sought an order precluding Green from introducing at trial any evidence related to the matters about which he asserted the privilege.

In granting the commission’s motion, the court rejected Green’s arguments that a total preclusion order would make the assertion of the privilege "costly." Cymaticolor, 106 F.R.D. at 550. While the Court recognized that invocation of the privilege was costly, it found that "Green’s risk of losing this case on the merits without the use of the evidence is not the type of cost that is constitutionally prohibited." Cymaticolor, 106 F.R.D. at 550 (citing Kimm v. Rosenberg, 363 U.S. 405, 408 (1960). Certain costs are constitutionally impermissible, including any cost so high that it forces an abandonment of the privilege, such as the loss of employment or state contracts. Spevack v. Klein, 385 U.S. 511, 515-16 (1967); LaSalle Bank Lake View v. Seguban, 54 F.3d at 389(citing cases).

Another example of a broad preclusion order is found in SEC v. Benson, 657 F. Supp. 1122 (S.D.N.Y. 1987). The Commission charged Mason Benson with making false and misleading statements and material omissions of fact to his company’s investors and auditors about his scheme to misappropriate funds from his company. Benson, 657 F. Supp. at 1125. In response to the complaint, Benson submitted an answer containing general denials and affirmative defenses. Benson, 657 F. Supp. at 1128-29. During discovery, Benson claimed his Fifth Amendment privilege and refused to respond to discovery of his evidence supporting the contentions in his pleadings. Id. at 1129. As a result, the SEC moved for sanctions, which the district court granted in the form of a preclusion order barring Benson from offering evidence in regard to matters on which he had asserted the privilege. Id. In granting the Commission’s subsequent motion for summary judgment, the district court stated that a defendant, "[b]y hiding behind the protection of the Fifth Amendment as to his contentions, ... gives up the right to prove them. By his initial obstruction of discovery and his subsequent assertion of the privilege, defendant has forfeited the right to offer evidence disputing the plaintiff’s evidence or supporting his own denials." Id.

One circuit has questioned the broad preclusion orders in Cymaticolor and Benson. SEC v. Graystone Nash, Inc., 25 F.3d 187, 192 (3d Cir. 1994). In Graystone, the district court barred the defendants, who had asserted their Fifth Amendment privilege during depositions, from offering any evidence to contest the Commission’s motion for summary judgment. The Third Circuit reversed because the district court did not balance the defendant’s interests in claiming the privilege against the Commission’s entitlement to equitable treatment in discovery. Graystone, 25 F.3d at 192-94. Factors the district court should consider include the prejudice the plaintiff suffers because of the defendants’ attempts to present evidence on their own behalf and whether the plaintiff is prevented from obtaining the evidence withheld by invocation of the privilege. Id At least one commentator has criticized the Graystone court’s analysis because the Graystone court seems to constrict its prejudice analysis to the evidence the SEC was able to obtain instead of the evidence the SEC was denied by the defendants’ invocation of the privilege. Comment: Self-Incrimination, Preclusion, Practical Effect and Prejudice to Plaintiffs: The Faulty Vision of SEC v. Graystone Nash, Inc., 61 Brooklyn L. Rev. 275, 298-99("The Third Circuit’s condemnation of total preclusion orders as unconstitutional was portentous of its defendant friendly balancing test. ... This test gives those invoking the privilege license to prejudice the opposing party in every civil case, albeit to varying degrees. Furthermore, the Third Circuit’s test is based on factually dissimilar and doctrinally unclear authority. The court compounded the prejudicial effect of this test by defining prejudice very narrowly. Instead of focusing on the benefits the SEC was deprived of, the court’s analysis focused on the information that the SEC was able to obtain despite the defendants’ assertion of privilege.").

At this time it is difficult to predict the effect of Graystone on the Commission’s ability to obtain preclusion orders in future cases. Though the Second Circuit in 4003-4005 5th Ave., Brooklyn, NY, applied a type of balancing test; The Second Circuit stated that upon a timely request by the person asserting the privilege, courts should explore all possible ways to strike a fair balance to accommodate the goal of permitting as much discovery as possible to be presented in the civil litigation despite the assertion of the privilege. 4003-4005 5th Ave., Brooklyn, NY, 55 F.3d at 84. it does not appear to be nearly as stringent as the Graystone test. At a minimum, if defendants purposefully manipulate and abuse the discovery process through their invocation of the privilege, even under the Graystone test courts should provide the plaintiff with some type of relief.

V. Stay of Proceedings

Some defendants attempt to avoid the effect of adverse inferences and preclusion orders by moving to stay the civil proceedings until the conclusion of pending or potential criminal proceedings. SEC v. Musella, Fed. Sec. L. Rep. (CCH) Para. 99156, 38 Fed. R. Sev. 2d 426 (S.D.N.Y. 1983). However, if in support of their motion defendants only raise fears of the adverse inference or preclusion, their efforts will be unavailing.

Courts are not constitutionally required to stay civil enforcement proceedings pending the outcome of parallel criminal proceedings. SEC v. Dresser Industries, Inc., 628 F.2d 1368, 1375 (D.C. Cir.)(en banc), cert. denied, 449 U.S. 993 (1980); SEC v. Grossman, 121 F.R.D. 207, 209-210 (S.D.N.Y. 1987). In its discretion, a court may stay civil proceedings or postpone discovery when the interests of justice seem to require such action. Dresser, 628 F.2d at 1375 (citing United States v. Kordel, 397 U.S. 1, 12 n.27 (1980); Grossman, 121 F.R.D. at 209-210. Because of the SEC’s need to respond quickly to alleged violations, and because the Commission cannot always wait until the Department of Justice has completed criminal proceedings, courts should not stay parallel civil enforcement proceedings "in the absence of ‘special circumstances’ in which the nature of the proceedings demonstrably prejudices substantial rights of the investigated party or of the government." Dresser, 628 F.2d at 1377 (citing Kordel, 397 U.S. at 11-13). Courts have generally not found that adverse inferences rise to the level of "special circumstances" necessary under the Dresser test, and therefore have not been willing to stay civil proceedings because of this concern alone.

For example, in SEC v. Musella, Fed. Sec. L. Rep. (CCH) Para. 99156, 38 Fed. R. Serv. 2d 426 (S.D.N.Y. 1983), the defendant moved to stay the civil enforcement action pending completion of related criminal proceedings. The defendant raised two arguments in support of his motion. First, the defendant argued special circumstances existed because the parallel civil and criminal proceedings were simply an improper stratagem to pressure him into invoking the privilege, thereby creating the inference. Id. As evidence of this theory, the defendant claimed that the government did not have a viable theory for criminal liability. Accordingly, only by convening a grand jury, forcing the defendant to assert the privilege, and thereby creating the inference, could the government hope to win its civil enforcement case. Id. The court rejected this argument by finding that the government had a viable theory for criminal liability under the relevant securities laws and that the SEC was acting in furtherance of legitimate public purposes. Id.

Second, the defendant "express[d] discomfort at having to choose between testifying in a deposition in a civil action, or asserting his fifth amendment privilege." Id. In rejecting this concern, the Musella court found that "the discomfort of the defendant’s position does not rise to the level of a deprivation of due process. Others have faced comparable circumstances; the choice may be unpleasant, but it is not illegal, and must be faced." Id.

Another example is found in Grossman. In that case, the defendants requested a stay of their civil action during the pendency of criminal proceedings so they would not have to assert the Fifth Amendment privilege and thereby create adverse inferences which could be used against them in their civil proceedings. Grossman, 121 F.R.D. at 210. Though empathetic with the defendants’ dilemma, the Grossman court relied on Dresser and Musella in finding that special circumstances did not exist to stay the civil proceedings. Id.

VI. Summary

While defendants subject to civil and criminal securities fraud proceedings often seek shelter behind the Fifth Amendment, that shelter comes at a price: the risk of an adverse inference or a preclusion order in the civil enforcement proceedings. Though defendants often complain that that cost is too high, many courts are unsympathetic to their pleas, recognizing that the SEC’s enforcement efforts should not be stymied by Fifth Amendment silence.

Scott B. Hamilton
is a Special Trial Counsel for the U. S. Securities and Exchange Commission in Chicago. He received his Undergraduate Degree from Duke University in 1980 and his Law Degree in 1984 from the University of Illinois-Urbana.

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