Securities Fraud Archives - That's Not Market

SEC Warns of SAFE Investment Instrument Popular in Equity Crowdfunding Campaigns

The SEC issued a bulletin warning investors about SAFE securities used in equity crowdfunding offerings.

Issuers in equity crowdfunding campaigns have offered various types of securities since it became legal to do so, such as various classes of stock, notes and instruments known as SAFE instruments. ‘SAFE’ stands for ‘Simple Agreement for Future Equity.’

SAFEs were originally designed to be an alternative to convertible notes for early-stage technology investments. The idea was that they would become simple, standardized vehicles for investing in very young companies without dealing with a lot the terms needed to make a convertible note or stock investment.

As the SEC points out, a SAFE is not like investing in common stock. It is an agreement that converts into issuer securities in the event of future triggering events, such as a future investment round, an IPO, a change of control or a liquidation.

Some people seem to think of them like convertible notes. However, convertible notes have maturity dates, among other terms. SAFEs do not and may never convert. SAFEs are more like derivative contracts with springing conversion based on listed events.

SAFEs have been increasing in use in the venture capital and angel investing worlds, and more recently other investors have gained some exposure and comfort with them. However, the SEC wants investors to know that:

SAFEs do not represent a current equity stake in the company in which you are investing.
SAFEs may only convert to equity if certain triggering events occur.
Depending on its terms, a SAFE may not be triggered.

To the people who have seen them before, none of this is a surprise. To a new investor, the SEC is concerned that these terms may be unexpected. As the SEC said:

SAFEs were developed in Silicon Valley as a way for venture capital investors to quickly invest in a hot startup without burdening the startup with the more labored negotiations an equity offering may entail. Oftentimes, for the venture capital investor, it was more important to get the investment opportunity, and possible future opportunities, with the startup than it was to protect the relatively small investment represented by the SAFE. In addition, the various mechanisms of the SAFE, from the triggering events to the conversion terms, were designed to best operate in the context of a fast growing startup likely to need and attract additional capital from sophisticated venture capital investors. This may or may not be the case with the crowdfunding investment opportunity you are exploring.

SAFEs can make a lot of sense to particular parties in particular deals, but investors such as crowdfunding investors should make sure to understand exactly what rights they have in what they are purchasing.

SEC issues warning about SAFE instruments in equity crowdfunding campaigns.

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 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.

A Couple of New Securities Litigation Cases from the Supreme Court

The Supreme Court issued a couple of securities litigation opinions today. A snapshot:

Amgen Inc. v. Connecticut Retirement Plans and Trust Funds

Held: Proof of materiality is not a prerequisite to certification of a securities-fraud class action seeking money damages for alleged violations of Securities Exchange Act of 1934 Section 10(b) and Rule 10b–5.

A quick reminder: Elements of an implied Section 10(b) cause of action for securities fraud are:

a material misrepresentation or omission by the defendant;
scienter;
a connection between the misrepresentation or omission and the purchase or sale of a security;
reliance upon the misrepresentation or omission;
economic loss; and
loss causation.

Basic v. Levinson, an important case in the securities law area, provided, among other things, that fraud-on-the-market can establish the reliance element.

In addition, to certify a class, a plaintiff must also establish that the questions of law or fact common to class members predominate over any questions affecting only individual members. They are fighting for the group, so to speak.

Considering whether to certify a class in a securities fraud case, the court looked at whether proof of materiality is needed to ensure that the common questions of law or fact predominate over individual questions as the litigation progresses. The court said ‘no’ because:

materiality is judged according to an objective standard, it can be proved through evidence common to the class; and
a failure of proof on the common question of materiality would not result in individual questions predominating. Instead, it would end the case, for materiality is an essential element of a securities-fraud claim.

The second point was a focus of the dissenting justices, which said that the failure to establish materiality retrospectively confirms that:

fraud on the market was never established;
questions regarding the element of reliance were not common; and
therefore, certification was never proper.

Therefore, the dissent said that the plaintiffs should not be excused at certification that questions of reliance are common merely because they might lose later on the merits element of materiality. Because a securities-fraud plaintiff invoking fraud-on-the-market to satisfy the certification rules should be required to prove each element of the theory at certification in order to demonstrate that questions of reliance are common to the class. However, they lost.

Gabelli v. Securities and Exchange Commission

The Investment Advisers Act makes it illegal for investment advisers to defraud their clients and authorizes the SEC to bring enforcement actions against fraudsters. To do this, the SEC must file suit “within five years from the date when the claim first accrued.”

So, what does that time limit mean?

In this case, the SEC sought civil penalties in 2008 for fraud allegedly committed from 1999 until 2002. The SEC argued that the statute of limitations did not begin to run until the SEC discovered or reasonably could have discovered the fraud.

Held: The five-year clock in begins to tick when the fraud occurs, not when it is discovered.

The SEC argued that because of the fraud aspect, a plaintiff may not know it has been injured so the statute of limitations should begin at discovery.

The court said that it has never applied the discovery rule where the plaintiff is not a defrauded victim seeking compensation, but is instead the government bringing an enforcement action for civil penalties. The government is a different kind of plaintiff whose purpose, in the case of the SEC, is to root out fraud. The discovery rule helps to ensure that the injured get compensation, but civil penalties go beyond compensation, are intended to punish and label defendants wrongdoers.

In addition, deciding when the government knew or reasonably should have known of a fraud would also present particular challenges for the courts, such as determining who the relevant actor is in assessing government knowledge, whether and how to consider agency priorities and resource constraints in deciding when the government reasonably should have known of a fraud, and so on.