Category: SEC Rules and Regulations

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)

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.

 

SEC To Vote On Rules For General Solicitation In Some Private Offerings

It has been quite a while since the SEC proposed rules relaxing the prohibition of general solicitation in Rule 506 and Rule 144A offerings.  The criticism to the proposed rules flowed from issuer and investor advocate groups for a variety of reasons.  These rules are required by Section 201(a) of the JOBS Act.

According to WSJ MarketWatch, the SEC will vote on the proposal on July 10.

At this point, it may be worth going back through the proposal to be ready for the new rules.  Issuers will be anxious to begin advertising.  However, the proposal includes onerous requirements for verifying investor eligibility.  We look forward to seeing what changes, if any, the SEC plans to make to the proposed rules.

 

SEC Highlights Warnings About Unregistered Broker-Dealers in Private Oil And Gas Offerings

The SEC is taking notice of private oil and gas offerings and has increased its scrutiny of these deals. They have noted the recent increase in fraud cases for these deals at the federal and state levels. Thus, the SEC has released an Investor Alert for Private Oil and Gas Offerings. And the first thing they recommend to investors approached to invest?

“Is the person recommending the investment registered? Most people offering you securities must be registered as a broker with the SEC and must be a member of the Financial Industry Regulatory Authority, or FINRA.”

The SEC cautions that being registered is not a seal of approval and that there may be conflicts of interest between the broker-dealer and the issuer.

In a general alert regarding the oil and gas industry, it is not surprising to find the SEC focused on the broker-dealer issue. Many advisors (including this writer) have been approached to sign off on an offering sales arrangement without a licensed broker-dealer with the explanation that:

  • “I do this all the time and it has never been a problem.”
  • “I am not acting as a broker-dealer, just a consultant who gets paid when the investment closes.”

Unfortunately for the would-be commission-eers, the SEC and state securities authorities do not share that analysis.

As the SEC said in the alert:

“If someone who is not registered solicits your investment, that person may be violating the law. One exception from broker registration is available to employees of the company offering the securities and who engage in strictly limited sales activities. If you aren’t consulting a registered broker or adviser, you should consider doing so. A registered broker or adviser that is familiar with the oil and gas industry and not connected to the offering can help you analyze the investment. Most importantly, working with a registered broker or investment adviser affords you certain legal protections.”

The SEC then illustrated benefits of using a licensed professional to assist in the investment decision:

Keep in mind that if the investment opportunity is an outright fraud, the written materials may look legitimate and every question you have about the opportunity may be answered to your satisfaction, but that doesn’t make any of it true. It is important to conduct your own independent research. One good way to do that may be to engage an investment professional specializing in oil and gas.”

It should be instructive to practitioners that in the course of a general industry investor alert, the SEC chose to highlight the risks of dealing with unlicensed broker-dealers. They are still clearly focused on this issue. Although some bad actors promote these deals, hoping to stay under the radar is a bad strategy for the promoter, issuer and investor.

While Feds Increase Insider Trading Enforcement, Other Feds Increase Insider Trading Activity, Part 2

In this previous post, I discussed the federal government’s newly aggressive enforcement of insider trading laws while federal government employees seemed to be providing tips to investors about pending government decisions that impact share prices of health care companies.  In the corporate world, this is known as “tipping” material non-public information and has severe consequences.  In the government world, “Congress and the executive branch — along with the reporters and lobbyists who track them — are accustomed to a relatively unfettered exchange of information, compared with the more regulated environment on Wall Street.”

This reminded me that in April 2013, Congress passed a bill striking down a key provision of the federal law prohibiting insider trading by members of Congress and their staff and high-level executive branch employees.  It is amazing that this was not the law until 2012.  However, the STOCK Act provided that securities transactions would be reported within 45 days and filed electronically so people could actually see it.

Congress voted to kill the broad disclosure provisions without hearings or public notice due to laughable national security and personal safety concerns.  According to a report on the matter:

“Virtually all the cybersecurity, national security, and law enforcement experts interviewed during this study noted that making this information available in this fashion fundamentally transforms the ability (and the likelihood) of others — individuals, organizations, nation-states — to exploit that information for criminal, intelligence, and other purposes.”

In addition, several groups representing the interests of federal employees have criticized the law.

Let us not forget that directors, officers and holders of 10% or more of a public company must disclose transactions in that company’s stock:

  1. Publicly on EDGAR, and
  2. Within 2 business days of the transaction.

I guess those people don’t have the same security concerns as federal employees.

60 Minutes confronts John Boehner generally about insider trading rules for federal employees (at 2:08) and Nancy Pelosi specifically about her participation in the Visa IPO (at 3:00 and Pelosi’s hilarious response at 3:15).

 

 

While Feds Increase Insider Trading Enforcement, Other Feds Increase Insider Trading Activity, Part 1

There has been much ink spilled about the SEC’s recent aggressive moves on insider trading allegations, from Rajat Gupta and Goldman Sachs to its pursuit of Steven Cohen of SAC Capital fame to calls for scrutiny of Rule 10b5-1 Plans.

However, lost in the shuffle to punish people who made more money than other people in the stock market is the recent news about federal employees engaging in conduct that is far worse.

The Washington Post (who hasn’t objected to the behavior of federal employees since January 20, 2009) today noted that hundreds of federal employees were told of important Medicare decisions weeks in advance of public release, which was also just before trading of shares in firms impacted by the decision spiked.  The public shouldn’t be alarmed because “agency officials said they take care to safeguard information and carefully vet which employees have access to it.  Employees are educated regularly about he need for confidentiality and CMS documents are often stamped with warnings about early disclosure.”

Sen. Charles Grassley said that this should sound an alarm and should result in better controls to avoid unfair access to information.

Great.  More rules that won’t be followed by people who will not be punished for engaging in behavior that will cause the government to destroy the lives of non-public sector employees.  So the answer is to talk about more rules for making illegal behavior super-illegal.  That should solve everything.

Exchange Offer Qualifies for Exemption From SEC Blackout Period Rules

In a no-action letter, the SEC stated its view that officers and directors may participate in an exchange offer during a blackout period. Pfizer’s request for SEC interpretive relief is here.

Background

Pfizer owns a bunch of shares of Class B supervoting common stock of Zoetis, which recently went public.  The companies expect to convert these shares into plain vanilla shares of Class A common stock.  Pfizer wants to give its shareholders the chance to own Zoetis shares through an exchange offer without forcing them to take the Zoetis shares, such as through a spin-off.  To get the Zoetis shares, the shareholder would have to affirmatively participate in the exchange offer by giving up a certain number of Pfizer shares.

The Problem

Regulation BTR prohibits an officer or director from certain transactions with the company’s stock during a blackout period, a period when the ability to sell to engage in transactions in an individual account plan is suspended by the company or a fiduciary of the plan.  Pfizer said it looks like the exchange offer will run headlong into a blackout period.  This would prevent Pfizer officers and directors from participating.

Exemptions from Reg BTR include M&A deals and divestitures, but exchange offers are not necessarily included.  Pfizer thinks they should be saying that Reg BTR purpose to  equalize the treatment of corporate executives and rank-and-file employees and align the interests of directors and executive officers would be served through a transaction conducted pursuant to the SEC’s tender offer rules.

The Result

The SEC agreed, noting that:

  • the exchange offer is solely for the purpose of divesting Zoetis from Pfizer;
  • the exchange offer is subject to, and will comply with, Exchange Act Rule 13e-4 or Regulation 14D under the Exchange Act;
  • a suspension of activity in the plan participants’ accounts (as communicated by the administrators to Pfizer) is imposed by the administrators to enable them to allow participants and beneficiaries of the plans to elect to participate in the exchange offer while maintaining an accurate accounting of the account balances of such participants and beneficiaries; and
  • Pfizer directors and executive officers would continue to be permitted to tender into the exchange offer during a blackout period, but would not otherwise be permitted to directly or indirectly purchase, sell or otherwise acquire or transfer Pfizer common stock during the blackout period if the shares involved were or would be acquired in connection with service or employment as a director or executive officer.