Securities Fraud Archives - That's Not Market

Equity Crowdfunding Risks and Liabilities – Yes, They Do Exist

Sorry startups, you actually have to be careful with equity crowdfunding disclosures. There is substantial risk of liability for securities fraud.

Based on discussions with the equity crowdfunding-curious, people seem to believe that equity crowdfunding is the wild west where anything goes. Raise lots of money and do it cheaply! Do what you want, say what you want and the SEC does not care! Look at the Form C’s, there were probably no lawyers anywhere near them. Think of the savings!!!!

None of that is true.

Done correctly, an equity crowdfunding offering should be done with as much care as any private placement. The actual information requirements are more extensive than a typical Rule 506 offering. Most importantly, crowdfunding issuers are subject to the same liability as any other securities selling issuer.

Securities Act Section 4A(c) provides that an issuer will be liable to a purchaser of its securities in a transaction exempted by Section 4(a)(6) if the issuer, in the offer or sale of the securities, makes an untrue statement of a material fact or omits to state a material fact required to be stated or necessary in order to make the statements, in light of the circumstances under which they were made, not misleading . . .

Sound familiar? What is the difference between this liability and private placements? Equity crowdfunding is done publicly to more people who are potential claimants.

What does this mean for issuers? It means the Form C and the offering page on the platform site need to be done carefully and in compliance with SEC rules. Those rules sound a lot like watered down Regulation S-K rules for MD&A, description of securities, related party transactions, etc… If you have never complied with them, good luck doing this without experienced help.

Well, at least the platforms are safe, right? They are just dumb pipes for crowdfunding deals and have no responsibility for what the issuers do on their site, right?

Well, no. While the SEC did not impose issuer liability on the platforms, it specifically declined to exempt the platforms from liability under Section 4A(c). Why? So investors could bring suits against the platforms to make sure that the platforms take steps to keep from becoming conduits of fraud.

The SEC believes that the platforms should take steps to protect themselves. Congress provided them a defense if they could not have known of an untruth or omission in the exercise of reasonable care. In other words, the “head in the sand” defense will not work. In addition, I have seen them provide and even require standard language and provisions in their issuers Form Cs and offering pages. I doubt the SEC will ignore this if this becomes misleading.

As the SEC stated:

These steps may include establishing policies and procedure that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information.

We are coming up on the one year anniversary of equity crowdfunding. It is still very early in the equity crowdfunding world to see where the liability issues will shake out. However, it is clear that the SEC and the state securities regulators take these liability issues seriously, and the issuers and platforms should too.

Equity Crowdfunding. Missing Category: Liability

Insider Trading Law Tightens Up for Tippers and Tippees

The Supreme Court speaks about insider trading, and it is not good for tippers and tippees.

I’m still going through the backlog of recent stuff. Here’s an important update on insider trading.

For the first time in a long time, the Supreme Court provided new guidance on insider trading laws. The government had suffered a few high-profile defeats in this area over the last few years, but Salman v. United States provided more insight into indirect liabilities for insider trading while providing more ammunition to the government to go after indirect (tippee) insider trading defendants.

In Salman, A was an investment banker in Citigroup’s healthcare investment banking group. Over time, he regularly tipped off B, his brother. B also provided the information to other people, including C, B’s friend who was also A’s brother-in-law. A tangled web and all that . . .

In the classic Dirks case, a tippee, in this case C, is exposed to liability to insider trading if the tippee participates in a breach of the tipper’s fiduciary duty. The test is whether the insider will benefit, directly or indirectly, from the disclosure. Disclosure without personal benefit is not enough. However, a close, personal relationship can create an inference of benefit.

In 2014, the Second Circuit in Newman, a case involving a more distant relationship between the traders and the insider information, did not permit the inference without proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.

The Ninth Circuit and the Supreme Court disagreed.

The Supreme Court said that the test is whether the insider personally will benefit, directly or indirectly, from the disclosure. Disclosure without personal benefit is not enough. However, the benefit can be inferred from objective facts and circumstances such as a relationship between the parties that suggests a quid or quo or intention to benefit the tippee.

The takeaway is that insider trading is not worth it. If caught, it is not that difficult to convict.* It just got easier. If the prosecution can show that there is a close enough relationship between the tipper and tippee, a jury can infer a benefit assuming that the transaction is no different than the tipper doing the trading and gifting the proceeds to the tippee.

*Sort of. There are some pending articles about some more difficult cases for the SEC and prosecutors.

Penny Stock Fraud – Why Penny Stock Email Promotions Are Bad For You

SEC cracks down on microcap securities fraud.

Like me, you may get bombarded with long email ads for some penny stock. They always tout how the stock is about to break out from $0.01/share to $0.05 or $10.00/share.

Did you ever get the sense that these may be scams. Gadzooks! Say it ain’t so!

The SEC today announced fraud charges and an asset freeze against the promoter of AwesomePennyStocks.com, a frequent trash dumper into my email accounts.

It charges that John Babikian used his sites for a “scalping” scam with the stock of America West Resources Inc. (AWSRQ). AWSRQ was low priced and thinly traded. Babikian fired off about 700,000 emails touting the stock. However, he failed to disclose that he owned 1.4 million shares of AWSRQ and was ready to sell them through a Swiss bank. The stock took off, and he made “ill-gotten” gains of more than $1.9 million.

The Babikian case is another example of the SEC’s focus on microcap stock fraud.

“The Enforcement Division, including its Microcap Fraud Task Force, is intensely focused on the scourge of microcap fraud and is aggressively working to root out microcap fraudsters who make their living by preying on unwitting investors,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.

Proving that the SEC has some teeth when it needs them,

The court’s order, among other things, freezes Babikian’s assets, temporarily restrains him from further similar misconduct, requires an accounting, prohibits document alteration or destruction, and expedites discovery. Pursuant to the order, the SEC has taken immediate action to freeze Babikian’s U.S. assets, which include the proceeds of the sale of a fractional interest in an airplane that Babikian had been attempting to have wired to an offshore bank, two homes in the Los Angeles area, and agricultural property in Oregon.

Microcap Fraud Crackdown Continues At SEC

SEC’s efforts to combat microcap fraud continue as it suspends trading in dormant shell companies. Commence Operation Shell-Expel!

One favorite technique of microcap fraud operators is to use shell companies as vehicles for pump-and-dump schemes. The SEC has tried over the years to clamp down on operators who take advantage of unsuspecting investors through these types of companies. For example, the SEC recently announced a microcap fraud task force to deal with fraud involving microcap securities.

Securities and Exchange Commission cracks down on Microcap Fraud.

In this regard, the SEC has also announced that it has taken a proactive step in its shell company enforcement. It has suspended trading in 255 dormant shell companies of the type it describes as “ripe for abuse in the over-the-counter market.”

“A frequent element in pump-and-dump schemes has been the use of dormant shells,” said Andrew J. Ceresney, director of the SEC Enforcement Division. “Because these shells all too often are used by those looking to manipulate stock prices, we will continue to protect unwary investors by suspending trading in shells.”

Operation Shell-Expel has been in effect since 2012. The SEC has been scrutinizing penny stocks and looking for inactive companies. Trading is then suspended until updated financials are provided. Since this is generally unlikely, the trading suspension ends the value of the dormant company to scammers.

Due to the number and low profile of dormant companies, enforcement this sector can be a challenge.

“Policing this sector of the markets can be a challenge,” said Margaret Cain, a microcap specialist in the Office of Market Intelligence. “There is often little or no reliable information about a microcap issuer, and the sheer number of these companies stretches law enforcement resources thin and makes this sector particularly dangerous for investors. The approach we take with Operation Shell-Expel is both economical and efficient as the SEC continues its commitment to preventing microcap fraud.”

Insider Trading – A Contrarian Take From CNBC

Should insider trading be illegal?

John Carney at CNBC posted an interesting article posing the question about whether insider trading should be a crime. In light of Michael Steinberg’s conviction for securities fraud due to his activities at SAC Capital, Carney asks who were the victims and what was the harm?

SAC Capital has been under fire for alleged insider trading. One trader was recently convicted.

In Steinberg’s case, part of the facts involved trading on early access to Dell’s earnings. Why is this a big deal?

But it’s hard to see how Steinberg’s acquisition of Dell’s earnings a day early hurt the company in any way. His trading may or may not have moved the stock price a bit but the actual release of the earnings moved it more.

Does Dell have an intellectual property right in its earnings? We don’t really recognize all corporate secrets or corporate information as protected intellectual property, much less property whose unauthorized use gives rise to criminal sanctions. There are certain categories—trade secrets, trademarks, copyrights—that are protected. But earnings aren’t trade secrets. Dell released them the very next day.

It is important to remember that Steinberg’s trading did not involve face-to-face arm’s length transactions with the counterparties. They were nameless and faceless people who never met Steinberg, knew Steinberg was in the market to buy or sell Dell shares or placed their orders with any knowledge of Steinberg and what he may have known or not known, disclosed or not disclosed. As Carney points out, regardless of what Steinberg did, each one of them would have acted in the exact same way.

What about the people who bought the shares of Dell on the day Steinberg was selling? Again, they would have been in exactly the same position regardless of whether Steinberg traded or not. Arguably, they were able to buy at a slightly better price because Steinberg’s trades would have pushed the stock slightly in the direction the stock actually moved when the earnings became public.

You’ll sometimes hear it said that the people on the other side of Steinberg’s trades were harmed because they wouldn’t have bought the shares if they had the same information he had. But that’s precisely the wrong test. The question isn’t what would they have done if they also had inside information. It’s what would they have done if Steinberg hadn’t had his information? The answer is: exactly what they did anyway. Steinberg’s possession of inside information didn’t affect them one bit.

Carney comes to a similar conclusion that I have always believed. This type of insider trading is not about protecting people. It is about (1) punishing success and profit [Ed. This is more me than Carney], and (2) a gut reaction that this behavior is wrong and should be punished. It is about addressing moral qualms, not about stopping harm.

In this respect, Carney compares this type of insider trading to blue laws.

In other words, our ban on insider trading isn’t really about protecting investors or making markets function better. It’s about expressing a moral view, much like we do with Blue Laws that ban the sale of alcohol on Sundays.

Here it is important to note that there is a school of thought that suggests insider trading should be encouraged since it makes the market more efficient by sending information about the insiders’ views of the company into the market. There are entire schools of trading based on insider transactions and Section 16 filings.

And here is where he loses me:

There’s nothing necessarily wrong with encoding morality into securities laws.

Yes, there is. We see it everyday in garbage like the ridiculous executive compensation disclosure now imposed on companies. We see it in required environmental disclosure, cybersecurity disclosure and blood minerals disclosure that probably don’t apply to most companies.

We see it every time some activist jumps up to demand that the SEC impose disclosure requirements on all companies that comport with the activists’ agenda, regardless of whether it furthers the mission of the disclosure regime for SEC reporting companies: Do investors have the information they need to make an informed investment decision? End of story.

If those issues are material to the disclosing company, they will have to be discussed. If not, this is nothing more than an extra tax (by way of time and money spent to assess and produce this nonsense) on reporting companies to pay for the whims of some vocal activists, be they outside agitators or Congressmen (who were (and probably still are) able to trade on inside information illegally in a way that would send you or I to prison).

New Twist On Old SEC Enforcement Tool: Deferred Prosecution Agreements for Individuals

The SEC announced that it entered into a deferred prosecution agreement with an individual, a first for the agency.

Enforcement officials often use DPAs to encourage targets to come forward with information about illegal activities and to cooperate with investigations. The agency agrees not to prosecute, and the target agrees to behave.

In this case, the deferree, a hedge fund administrator, spilled the beans about his boss regarding misuse of about $1.5 million and lying to investors about the fund’s performance. The DPA discusses overstatements of fund returns and discrepancies in the net asset value, or NAV, used for internal and external purposes.

The SEC froze the fund’s and the boss’ assets and is preparing to distribute about $6 million to injured investors.

SEC Files Fraud Charges Against Wing Chau, One of the CDO Managers Profiled in Michael Lewis’ “The Big Short”

This won’t be good for the Wing chau defamation suit against Michael Lewis.

Some readers may be familiar with “The Big Short: Inside the Doomsday Machine,” Michael Lewis’ chronicle of the run up to the financial meltdown. I strongly recommend it. It is a great read.

In the book, there was a discussion of Wing Chau, who helped create and, in theory, manage some disastrous CDOs. He was not portrayed like the brilliant hedge fund managers who cashed in on the crash of real estate-backed securities. He was portrayed like a fool. For this, he sued Lewis for defamation.

I’m not sure if that case is ongoing or not, but the SEC has weighed in. Verdict: fraud charges against Chau for misleading investors in a CDO and for breach of fiduciary duties.

The SEC’s claims that Chau and his firm, Harding Advisory LLC, compromised their independent judgment as collateral manager to a CDO in favor of a hedge fund firm. The hedge fund, the awesomely named Magnetar Capital LLC, had invested in the equity of the CDO. Merrill Lynch structured and marketed the CDO. Harding was collateral manager for the CDO.

Specifically, the SEC claims that Harding agreed to let the hedge fund help select the subprime mortgage-backed assets underlying the CDO. This was not disclosed to investors.

The SEC claims that the influence of the hedge fund led Harding to select assets that its own credit analysts disfavored. In the tradition of criminal geniuses everywhere, in accepting the bonds, Chau wrote in an e-mail to the head of CDO syndication at Merrill Lynch:

“I never forget my true friends.”

The SEC claims that Chau understood that Magnetar was interested in investing as the equity buyer in CDO transactions, and that Magnetar’s strategy included “hedging” its equity positions in CDOs by betting against the debt issued by the CDOs. Because Magnetar stood to profit if the CDOs failed to perform, Magnetar’s interests were not necessarily aligned with investors in the CDO debt, which depended solely on the CDO performing well.

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 2^nd 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:

a securities listed on a U.S. exchange; or
a security purchased or sold in the United States.

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.

______________

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.