Do Section 10(b) and Rule 10b-5 Apply Outside of the U.S.?

Spoiler Alert: No, and this applies to civil and criminal matters, according to the Second Circuit.

Link:  U.S. v. Vilar 

Amid a selection of evidentiary and litigation-y claims, the recent 2nd Circuit case of U.S. v. Vilar did have some interesting nuggets for securities professionals.  Looking at an open issue following the U.S. Supreme Court case of Morrison v. National Australia Bank Ltd., the court looked at whether criminal liability under the Securities Exchange Act of 1934 extended to conduct outside the U.S.

Morrison was a civil case that limited Exchange Act Section 10(b) and Rule 10b-5 to domestic transactions in securities.

Background

The defendants were investment managers and advisers managing up to $9 billion before the tech bubble burst.  They offered select clients the opportunity to invest in securities that paid a high, fixed rate of interest, which were backed primarily by high quality, short-term deposits.  However a portion was invested in publicly traded emerging growth stocks.  See where this is going?

The bubble burst and the defendants were not able to meet the interest payments.  They created another investment vehicle and sold it to an investor, using the proceeds to settle a portion of the previous securities and for various personal expenses.  This investor complained to the SEC after demands to return her funds were met with questionable responses.

The defendants were convicted on a variety of securities, mail and wire fraud counts.

The Argument

Relying on Morrison, he defendants argued that their convictions should be reversed since their conduct was extraterritorial, or outside the U.S.

The court agreed and quoted Morrison for the proposition that when a statute gives no clear indication of an extraterritorial application, it has none.  Although Section 10(b) clearly forbids a variety of fraud, its purpose is to prohibit crimes against private individuals or their property, which is the sort of statutory provision for which the presumption against extraterritoriality applies (responding to the government’s examples of cases broadly applying statutes extraterritorially where the victims were government actors).  A statute either applies exterritorially or it does not, and once it is determined that  a statute does not apply extraterritorially, the only relevant question is whether the conduct occurred in the territory of a foreign sovereign.  In such a case, the court’s test is:

A securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.  More specifically, a domestic transaction has occurred when the purchaser has incurred irrevocable liability within the United States to take and pay for a security, or the seller has incurred irrevocable liability within the United States to deliver a security.

The Upshot

The conviction stands.  The conduct at issue was conducted in the United States, with ties to New York and Puerto Rico, which counts for the court’s purposes.

The defendants claimed that they structured the transaction carefully to avoid U.S. jurisdiction.  However, the court declined to “rescue fraudsters when they complain that their perfect scheme to avoid getting caught has failed.”

The Takeaway

The court summarized its conclusion on the relevant (to us) point as follows:

  • Section 10(b) and Rule 10b-5 do not apply to extraterritorial conduct, regardless of whether liability is sought criminally or civilly.
  • A defendant may be convicted of securities fraud under Section 10(b) and Rule 10b-5 only if he has engaged in fraud in connection with:
    1. a securities listed on a U.S. exchange; or
    2. a security purchased or sold in the United States.

Nasdaq Issues Preliminary Findings On Trading Shutdown

Nasdaq’s internal review of the hours-long trading shutdown of August 22, 2013 seems to show that its communications gear was overloaded.  Nasdaq said that it is working on the issue and will strengthen its systems.

Apparently, a flood of messages from NYSE Arca hit the Nasdaq system at a rate of over 2.5 times what the Nasdaq system was designed to handle.  Its capacity exceeded, the system degraded.

Contrary to some reports (or guesses), high frequency trading played no role in the shutdown.

 

SEC Issues Alert and Addresses Weaknesses of Investment Advisor Plans in Disruptions Caused By Weather

Following Hurricane Sandy, the SEC contacted investment advisors in the Northeast to try to understand how they were impacted by the storm.*  The SEC just released its findings, which it believes will help improve responses and reduce recovery time after “significant large scale events.”

Among the weaknesses noted by the SEC in certain advisors’ “business continuity plans,” or BCPs, were:

  • Some BCPs that did not adequately address and anticipate widespread events, such as adequate plans addressing situations where key personnel were unable to work from home or other remote locations.
  • Some advisers did not have geographically diverse office locations, and many smaller advisers had fewer geographically dispersed staff.
  • Some advisers did not evaluate the BCPs of their service providers.
  • Some advisers did not engage service providers to ensure that back-up servers functioned properly and relied solely on self-maintenance.
  • Some advisers did not adequately plan how to contact and deploy employees during a crisis, and inconsistently maintained communications with clients and employees.
  • Some advisers inadequately tested their BCPs relative to their advisory businesses.
  • Some advisers opted not to conduct certain critical tests because vendors provided disincentives or charged for testing.

The alert did not distinguish between large and small advisors or how appropriate BCP provisions addressing these weaknesses would be for smaller firms.  Geographic diversity is the most obvious example in that case.

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*Investment advisors are required to implement these types of BCPs under the SEC’s interpretation of Rule 206(4)-7.

 

Outsourcing Corporate Boards?

An interesting proposal by a couple of corporate law professors may cause you to rethink how companies populate their boards. 

Law professors M. Todd Henderson (U. Chicago) and Stephen M. Bainbridge (UCLA) have proposed a novel way to expand further the universe of corporate service providers by allowing the outsourcing of board functions.

The profs note that critics complain that the array of tasks for a board to deal with are too vast for a board to perform effectively.  They also note that “boards fail to police managers adequately or make good decisions” and that they are generalists without the breadth of experts the company may need.

First, boards generally, and exchange listed board committees specifically, have the ability to hire expert advisors directly without relying on company management.

However, this brings up a point that has bothered me for a while.  Before, and particularly after, Sarbanes-Oxley, the corporate governance “experts” have emphasized the need for independent board members, free of the influence of management.  However, with respect to the operations and performance of a company, that responsibility and information resides with management.

In other words, particularly in the post-Sarbanes-Oxley world, the most sensitive and important decisions are under the purview of the people with the least connection to the company and the least access to the information.  I understand the fear of conflicts of interest and the desire for input free of the influence of management, but this seemed to me to be a mismatched solution.

Basically, I’m not sure I agree with the critics.  You can point to specific governance horror stories, but there are thousands of public companies and many thousands more private companies where corporate boards operate adequately or even successfully.  There are actual instances of effective governance that pre-date Sarbanes-Oxley, if you can believe it.  In the case of policing management and making crucial policy decisions, why would you have those responsibilities rest with the individuals furthest removed from the company?

In addition, there are many examples of corporate boards with structures resembling the All Governance Expert Blue Ribbon Panel Paradigm that turned out to be miserable governance failures (*cough*Enron*cough*).

I know this was a bit of tangent, but it was my first reaction to the profs’ article.  There will be more.  It is recommended reading.

SEC Issues Stop Order For “IPO”

Here’s something you don’t see everyday.

Typically, when going through the SEC registration process, you file a registration statement, the SEC comments, you respond and file an amendment, lather, rinse and repeat until all comments are resolved and the issuer is ready to go effective.

However, the SEC can issue a stop order to prevent the use of a registration statement if the registration statement is somehow deficient. This brings us to Counseling International, Inc.

Counseling International originally filed a Form S-1 in August 2012. It filed various amendments through June 2013. There does not seem to be an order declaring it effective, and the comment letters and responses are not yet posted on EDGAR (which occurs some time after effectiveness).

It seems to be a stretch to call this an IPO as the Form S-1 covers the resale of the shares by selling shareholders, there is no underwriter, there is no securities exchange listing and the company’s assets consist of about $21,000.  However, it is the initial filing by a non-reporting company.

On August 22, 2013, the SEC issued a stop order after it determined that the registration statement contained false and misleading information, identified by the SEC as:

  • failure to disclose the identity of control persons and promoters; and
  • false description of the circumstances of the departure of the former chief executive officer.

The prospectus provides the following language, which we guess missed some crucial details:

“The Company was founded by Layla Stone, who served as the director and chief executive officer of the Company until she sold all of her equity interest in the Company to Maribel Flores on October 19, 2012, and resigned from such positions on the same date. On October 19, 2012, Ms. Flores became the sole director and officer of the Company.”

Until the comment and response letters are posted, it will be difficult to know exactly what went on, but it must have been a serious situation for the SEC to take this drastic measure. How drastic, you ask?

First, the registration statement had a typical delaying amendment, so it would not have gone effective without SEC action in any case.

Second, Counseling International agreed to penalties, which include ineligibility to conduct a Rule 506 offering for five years or occupy any position with, ownership of or relationship to the issuer enumerated in Rule 506(d)(1). [Ed. Note: This second clause seems to apply to an individual, but the “Respondent” described in the stop order seems to be limited to Counseling International. Please let me know in the comments if I just missed something, but I had trouble making sense of this. It may be a boilerplate clause, but it is difficult to tell from the stop order document alone. The press release only refers to the ineligibility for the use of Rule 506 as a penalty.]

The SEC had the following to say, which highlights how they viewed the situation:

“Rarely do we have the opportunity to prevent investor harm before shares are even sold, but this stop order ensures that Counseling International’s stock cannot be sold in the public markets under this misleading registration statement.”

Links:
Most recent amendment to Form S-1
Stop Order
SEC Press Release

Whether Investment Notes Are(n’t) Securities Is Kinda Important To A Jury Verdict For Securities Fraud

Apprarently, the question about whether something is or is not a security has become a hot issue, judging by two consecutive blog entries.

Link:  U.S. v. McKye

I noticed a case that primarily involves procedural issues for trial, a subject to which I have not paid much attention since law school.  However, the substance of the appeal involved securities fraud and whether or not the instruments in question were securities.

McKye was convicted of securities fraud and conspiracy to commit money laundering.  As it turns out the McKey case provides an interesting take for transactional lawyers on how this issue may come up at trial.

Background

McKye prepared revocable trusts for clients and financed the costs with loans for those who could not pay.  Promissory notes represented the loans, and in some cases, there would be a lien on the client’s house.  He also sold “investment notes” that offered a guaranteed annual return of 6.5% to 19.275%.  There was some documentation showing a pledge of collateral supporting the investment notes, which turned out to be from the persons who financed the costs of the revocable trust services.

McKye and his salesmen told people that the instruments were backed by real estate notes and mortgages and that they were not securities.

McKye received about $5.9 million in proceeds from the sales of investment notes, which he used to pay other investors (you may know this structure as a “Ponzi scheme”) and to pay his own expenses.

At trial, McKye requested a jury instruction to determine whether the investment notes were securities.  The court said that the notes are presumed to be securities and that McKye failed to present evidence overcoming that presumption.  A jury instruction indicated that the notes were securities.

The Upshot

After a discussion about the analysis of whether a note is a security, the appeals court determined that the question of whether a note is a security is a mixed qustion of fact and law.  Mixed questions of fact and law must be submitted to a jury if they implicate an element of the offense.  In this case, securities fraud requires . . . the offer or sale of any security . . .”  Because the government was required to prove that the investment notes were securities as an element of its case, the trial court erred when it instructed the jury that the notes are securities.

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For those interested, here are some excerpts regarding the ‘note as security’ analysis, discussing the U.S. Supreme Court case of Reves v. Ernst & Young, the primary case in this area:
“Although 15 U.S.C. § 77b(a)(1) defines a security to include “any note,” the Supreme Court held in Reves that “the phrase ‘any note’ should not be interpreted to mean literally ‘any note,’ but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.””

 

“The Court then identified a list of notes falling “without the ‘security’ category,” to include (1) a note delivered in consumer financing, (2) a note secured by a mortgage on a home, (3) a short-term note secured by a lien on a small business or some of its assets, (4) a note evidencing a character loan to a bank customer, (5) a short-term note secured by an assignment of accounts receivable, (6) a note which simply formalizes an open-account debt incurred in the ordinary course of business and (7) notes evidencing loans by commercial banks for current operations.”

 

“The Court further explained that any note bearing a “family resemblance” to the enumerated notes also does not fall within the Act’s definition of a security. Id. at 65-67. It adopted a four-part test to determine whether a note meets the family resemblance test. Id. at 66-67. The four factors are: (1) “the motivations that would prompt a reasonable seller and buyer to enter into it,” (2) “the ‘plan of distribution’ of the instrument,” (3) the “reasonable expectations of the investing public,” and (4) “whether some factors such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.

 

 

When A Sale Of Real Estate Is(n’t) A Sale Of Securities

Searching for a legal argument port in a storm, the plaintiffs are left stranded as a condo sale is deemed not to be a security.

Link:  Salameh v. Tarsadia Hotel

We have seen the issue come up with investments as citrus groves, payphones (remember those?), country club memberships, timeshares, viatical settlements and fractional ownership in airplanes.

When is something other than a share of stock or a bond a security?

Well, the 9th Circuit just told us in Salameh v. Tarsadia Hotel when a condo/hotel room is not a security.

Background

The Hard Rock Hotel San Diego is a twelve-story, mixed use development with commercial space and 420 condo units.  The public was offered the opportunity to buy condos through what would be considered general solicitation in the securities world.  They could use the condos for 28 days per year.  The purchasers later signed a management agreement for the units months later, which was apparently required by the purchase agreement.

Something must have gone wrong, although it is not stated in the opinion.  The plaintiff-purchasers sued the hotel operator, developer, landowner, manager and real estate broker for various securities fraud related complaints.  They claimed that the sale of the condos and the later management agreements combined to form a security, the sale of which violated various parts of federal and California securities law.

The Upshot

The court decided that there was no security involved.  The court will find a security if there is money invested in a common enterprise with profits anticipated by virtue of others’ work, but there was no such arrangement here.  This is what we in the biz refer to as the Howey test*.

Contrasting a prior case** where condos were considered securities, the court stated that the plaintiffs allege no facts showing that:

  • purchase agreements and management agreements were offered as a package;
  • the management agreement was promoted at the time of sale; or
  • that the management agreement would result in investment profits.

In addition, it was stated in court documents that the agreements were executed eight to fifteen months apart.  The court had a difficult time accepting that signing two agreements months apart with separate entities had the economic reality of a single transaction or that the only viable use of the condos was as investment property, as opposed to short-term vacation homes.

As a result, there was no sale of security and, thus, no claims for relief under federal or state securities law.

*Based on SEC v. W.J. Howey Co., 328 U.S. 293 (1946)
**Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989)

Online Research Services. Worth It?

This can be a huge expense for a solo practitioner.  However, since I am not a litigator, time and search-fee intensive services like Lexis or Westlaw are not necessary.  Basic Google Scholar searches and the Delaware court websites can usually get specific cases I need (if any).

There are often questions related to corporate/securities law that come up where I need guidance, my arrogance notwithstanding.  For that reason, The Corporate Counsel website is great even if it is separate from the print newsletter and its archives, which is helpful but not necessary.  I also have a subscription to their sister site, Deal Lawyer, which seems to be money wasted.  There just is not enough substance there to be worth the fee.  I have used it for a couple of issues that would fall squarely into its area of expertise, but each time the site has come up short.  It either has nothing that addresses the question or the information it does have is not helpful or could have been accessed faster from the SEC’s EDGAR site.

That brings me to Other Research Provider (not named at this time).  They have great services for business lawyers looking for SEC documents that are not available on EDGAR or could easily be missed using EDGAR’s clumsy search engine.  However, like dealing with Lexis and Westlaw, there is no easy pricing guide.  You deal with salespeople as if you were buying a car.  Do you feel like you are being ripped off?  You probably are, at least in terms of paying more for the same service than the solo down the block.

Try getting a list of services for your subscription.  You get a one page .pdf sales sheet without the list of services.  They may be running specials next week or not.  At least with the Deal Lawyer site, I knew exactly how much I was paying and what I was getting without having to talk to a sales person.

At some point substitutes won’t cut it anymore, and I will need the service.  I will keep putting it off until it is unavoidable or they make the process less unenjoyable.