Category: Securities Regulation

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.
The Big Short
Michael Lewis, The Big Short. Short review: A good 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 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.

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

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)

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.

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.

 

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.