Author: db

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.

Solo Practice = Better Get To Know Your Computer System

Once again, I learn the value of adaptability.

Working diligently on my laptop with two external monitors for a three-screen setup, the two external monitors froze with the image of whatever they were displaying.  Since the cursor was on Display #2, for a moment it appeared that the computer froze.

After some research on the remaining active display, I learned that the problem was probably the docking station (Toshiba Dynadock).

One firmware update, one DisplayLink update, several reboots, lots of plugging and unplugging later, I am finally back up in running in triplicate!  The last piece of the puzzle was to unplug the docking station to get those images out of the memory and off of the two external displays.

Previously, the biggest issue with the docking station was due to the fact that if it was plugged in at startup, Windows wouldn’t launch.  This means unplugging it every time I turn the computer on.  Since the update, I have been able to boot up with the docking station attached to the laptop so far.  We’ll see if this continues.

Chalk up one hour of time not spent doing legal work and billing.

Nasdaq Among The Targets of Hacking Spree, According to Indictment

Three of the five alleged hackers are at large as the DOJ issues indictments in what I referred to the “largest such scheme ever prosecuted in the United States.”  The hackers, five Russian and a Ukrainian, stole more than 160 million credit card numbers from a number of payment processors, retailers and financial institutions.

Nasdaq was a target, but its trading platforms were not compromised.

Among the U.S. Attorneys mentioned in the article is Preet Bharara, who is having a big week.  He is also involved in the SAC Capital insider trading case.

SEC Pounces on Bitcoin Ponzi Scheme – In Securities Fraud, Everything Old Is New Again

Movie critics would call the scheme cliched and hackneyed.
Link:  SEC Charges Texas Man With Running Bitcoin-Denominated Ponzi Scheme

This week, the SEC charged McKinney, Texas-based Trendon T. Shavers with defrauding investors in a Ponzi scheme involving Bitcoin.  He may have raised more than $4.5 million in the scheme, but due to the Bitcoin-denominated transactions and vague SEC release, it is hard to tell.  The SEC also says that in more recent dollars, the 700,000 Bitcoin raised exceeds $60 million, which screams “We Want Headlines!!!!” to me.

Shavers’ vehicle was called Bitcoin Savings and Trust and he used the names “Pirate” and “pirateat40” to sell his dirty wares.  Despite the scary name, Shavers is probably just a Jimmy Buffet fan.

Jimmy Buffet, A Pirate Looks At Forty

The SEC claims Shavers claimed that investors would have no risk and huge profits over the Internet.  It appears that Shavers took in Bitcoin investments and then sent them out in withdrawals and interest payments while losing money in his investments and siphoning off funds for himself.  This is classic Ponzi scheme.  Nothing new or notable other than the Bitcoin angle, which isn’t that interesting considering other schemes that are far more imaginative.

 

Insider Trading – How Much Of A Factor Must The Material Non-Public Information Play In The Investment Decision?

Spoiler alert: Not much.

Link: United States v. Raj Rajaratnam

Raj Rajaratnam, former billionaire hedge fund manager, appealed his notorious insider trading conviction.  If you recall, he was the founder of the Galleon Group hedge funds who received insider information from contacts at McKinsey, Intel, Goldman Sachs and other hedge funds.

Among the issues raised at trial was whether the fraud counts should be vacated because the court told the jury that it could convict Rajaratnam if the “material non-public information given to the defendant was a factor, however, small, in the defendant’s decision to purchase or sell stock.  He claimed that this allowed to jury to convict without a causal connection between the inside information and the trade.

The court noted that under the misappropriation theory of insider trading, a person commits fraud “in connection with” a securities transaction in violation of Rule 10b-5 when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.  The Supreme Court in the O’Hagan case enshrined/created this theory to “protect the integrity of the securities markets against abuses by ‘outsiders’ to a corporation” who have access to confidential information that will affect the corporation’s security price but otherwise owe no duty to the corporation’s shareholders.

The court in this case endorsed the “knowing possession” standard* that is consistent with the cardinal rule of insider trading:

If you have a fiduciary or other duty to the company and hold material non-public information, disclose or abstain.

On this basis, the appeals court said that the district court’s instruction was more favorable to Rajaratnam than the legal standard.  Rather than merely be in possession of the information, the jury had to find that he used it in some manner to find him guilty of insider trading.  As a result, the jury instruction satisfied the “knowing possession” standard.

*The knowing possession standard became the law in the 2nd Circuit in United States v. Teicher and United States v. Royer.