Two cases challenging the SEC’s use of administrative proceedings based on the Constitution’s Appointment Clause are headed for the Circuit Courts. One, Duka v. SEC will be considered by the Second Circuit. A second, Hill v. SEC, will be heard by the Eleventh Circuit. Both courts concluded they had jurisdiction to consider the question. A recent Seventh Circuit decision, however, determined that district court’s do not have jurisdiction to consider such challenges. Bebo v. SEC, No. 15-1511 (7th Cir. August 24, 2015).
Laurie Bebo is a respondent in a pending Commission administrative proceeding. That case has been heard and is pending decision. The complaint alleged an accounting fraud at Assisted Living Concepts, Inc. Ms. Bebo was the CEO of the firm. Her answer raised, among other things, the issues presented here – that Section 928 of Dodd-Frank is facially unconstitutional under the Fifth Amendment because it gives the SEC unguided authority to select the forum and that the appointment clause was violated when the ALJ’s were selected.
While the Initial Decision has not been rendered in the administrative action, at its conclusion Ms. Bebo will have the right to pursue appeals through the SEC and to an appellate court, assuming the decisions are adverse. Instead, Ms. Bebo elected to file suit, invoking the district court’s jurisdiction under 28 U.S.C. § 1331. The complaint alleged, among other things, the two Constitutional issues presented in her answer. The district court dismissed the suit for lack of jurisdiction. The Circuit Court affirmed.
The statutory issue presented in the case, according to the Circuit Court, is one of jurisdiction: does the review afforded by 15 U.S.C. §78y bar district court jurisdiction over a constitutional challenge to the SEC’s authority when the plaintiff is a respondent in a pending administrative proceeding?
The inquiry here is claim specific. The Supreme Court held in Free Enterprise Fund v. PCAOB, 561 U.S. 477 (2010) that the administrative process does not bar all such claims. Rather, citing Thunder Basin Coal Co. v. Reich, 510 U.S. 200 (1994), Free Enterprise employed a three factor test to analyze the question. Those factors are: 1) if a finding of preclusion could foreclose all meaningful judicial review; 2) if the suit was wholly collateral to the statute’s review provisions; and 3) whether the claims are outside the expertise of the agency. Assessing these factors the Court concluded that “Read broadly, the jurisdictional portion of Free Enterprise Fund seems to open the door for plaintiff . . .”
That door was closed, however, by Elgin v. Dep’t of Treasury, 132 S. Ct. 2126 (2012).Elgin established “several key points that undermine Bebo’s effort to skip administrative adjudication . . .” First, the fact that her claims present facial constitutional challenges is not sufficient. Second “jurisdiction does not turn on whether the SEC has authority to hold § 929P(a) of Dodd-Frank unconstitutional, nor does it hinge on whether Bebo’s constitutional challenges fall outside the agency’s expertise.” Third, the claim that the fact finding capabilities in the administrative proceeding are more limited than those of a federal district court is not sufficient. Finally, the fact that Ms. Bebo may prevail in the administrative case which would obviate any review of her constitutional claims does not “render the statutory review scheme inadequate.”
While the claims here may be wholly collateral to the statutory review scheme, this point is not dispositive. Calling this question “unsettled,” the Court concluded that “the most critical thread in the case law is the first Free Enterprise Fund factor: whether the plaintiff will be able to receive meaningful judicial review without access to the district courts. . . The key factor in Free Enterprise Fund that rendered §78y inadequate is missing here.” Accordingly, the district court correctly determined that it does not have jurisdiction.
The Foreign Corrupt Practices Act was aimed at halting corrupt payments made to improperly influence foreign officials. In drafting the Act Congress chose not to impose liability on the foreign official involved in corrupt payments. While it might be argued that Congress did not intend to impose liability on those officials, that clearly has not been the case.
Vadim Mikerin is a Russian Federation official who is the most recent foreign official to pleaded guilty to charges tied to his role in an FCPA case. U.S. v. Mikerin, Cr. No. TDC -14-0529 (D.Md.). His guilty plea is one of two announced by the DOJ in connection with FCPA violations.
Mr. Mikerin, a resident of Maryland, was the Director of the Pan American Department of JSC Techsnabexport, or TENEX, from 2004 through 2010. He was also president of TENAM Corporation from late 2010 through October 2014. TENAX was a wholly owned subsidiary of the Russian Federation’s agency responsible for state property management. TENEX was a wholly owned subsidiary of another entity that was owned by the State Atomic Energy Corporation or ROSATOM. TENAX was the sole supplier and exporter of Russian Federation uranium and uranium enrichment services to nuclear power companies worldwide, according to the plea agreement. TENAX and TENAM were instrumentalities of the Russian Federation.
Transportation Logistics International, a Maryland based firm that is a domestic concern, contacted with TENEX to transport uranium from Russia to the United States from 1996 through 2013. This was part of a U.S. program to remove unsecured nuclear weapons from the former Soviet Union for cash.
Daren Condrey, a principal of Transportation Logistics, conspired with Mr. Mikerin and others over a ten year period beginning in 2004 to pay $2.1 million to Mr. Mikerin, according to the court papers. The money was funneled through a series of offshore shell companies in connection with the transportation contracts. The payments were concealed through the use of consulting agreements which used code words. In his plea agreement Mr. Mikerin admitted that the payments were made as part of a corrupt scheme to obtain unfair business advantage.
Mr. Mikerin pleaded guilty a one count superseding information charging him with conspiracy to commit money laundering. He has agreed to the entry of a forfeiture money judgment in the amount of $2,126,622. He will be sentenced on December 8, 2015.
Mr. Condrey pleaded guilty on June 17, 2015 to conspiring to violate the FCPA and to commit wire fraud. He will be sentenced on November 2, 2015. Initially his wife was also charged although those charges were dropped as part of a plea deal. Mr. Condrey’s plea was announced yesterday along with that of Mr. Mikerin. Previously, Boris Rubizhevsk of Closter, New Jersey, reportedly an adviser to Mr. Mikerin, pleaded guilty to conspiracy to commit money laundering. He will be sentenced on October 19, 2015.
The Russian Foreign Ministry stated the case raises “serious question,” according to the FCPA blog. This is not the first time that a foreign official has been criminally charged under U.S. law in connection with an FCPA conspiracy.
The battle lines are now clearly drawn over Newman and what constitutes impermissible tipping in violation of Exchange Act Section 10(b)(here). Previously, the Government filed a petition for certiorari arguing that Newman, which addressed the requirements of the Dirks personal benefit test put an impermissible “gloss” on Dirks. Specifically, the Government argued that Newman is inconsistent with the Dirks’ personal benefit test, that now there is a conflict in the circuits and law enforcement is being hindered in its war on insider trading (here). The Brief for Respondent Anthony Chaisson in Opposition, filed in U.S. v. Newman, No. 15-137 (S.Ct.), refutes those points.
Respondent’s brief argues four points: 1) The Second Circuit faithfully applied Dirks; 2) there is no conflict among the circuits; 3) this case is not an appropriate vehicle for consideration of this issue; and 4) granting certiorari would not be beneficial for the markets.
Respondent framed the question for decision as “Whether the evidence was insufficient to prove that the corporate insiders in this case received a personal benefit from disclosing information to particular tippees.” Following a lengthy review of the factual record which hews closely to the presentation in Newman, Respondent addressed the central question in the case, arguing that Newman is nothing more than Dirks revisited, followed and applied.
First, Dirks recognized that not every disclosure of inside information violates the law. Rather, there is only liability when the insider makes the material non-public information available to an outsider “improperly.” Since the position of the tippee derives from that of the insider, a “tippee is prohibited from trading on material nonpublic information only when he ‘knows or should know’ that ‘the insider has breached his fiduciary duty to the shareholders by disclosing the information,’” quoting Dirks.
Second, the “focus” of the inquiry in assessing tippee liability, Respondent argues, is “whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings,’” quoting Dirks. The Court went on to identify certain objective factors and circumstances that can justify an inference of personal gain. Those can include the fact thatwhere there is a relationship between the insider and the recipient that suggests a quid pro quo from the tippee or an intention to benefit the particular recipient. This can include situations where there is a gift because the tip and trade resemble trading by the insider himself. Here there was no evidence to support this.
Third, the Government’s argument focuses on a single sentence from the Newman opinion, according to Respondent, noting that a “personal benefit may be inferred from a personal relationship . . . where the tippee’s trades resemble trading by the insider himself followed by a gift of the profits to the recipient . . . such an inference is impermissible in the absence of 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.” While the Government claims the use of the word “exchange” cannot be reconciled with Dirks which does not impose such a requirement, Respondent contents that Petitioner misreads the Supreme Court’s decision. Under Dirks the insider must get something in return for the disclosure.
Fourth, Respondent contents that in fact the Government is attempting to alter Dirks: “ The Government asserts that an insider violates his fiduciary duty by disclosing information unless the insider ‘has a valid business public for selective disclosure’ or ‘mistakenly believes that information is not material or is already in the public domain.’ But that turns Dirks on its head. Dirks does not require the insider to prove some ‘legitimate’ reason for his disclosure to avoid liability. . . To the contrary, under Dirks, an insider is not liable unless the Government proves that ‘the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders,’” quoting Dirks. (emphasis original).
Respondent also contends that there is no split among the circuits – neither the Ninth Circuit’s recent decision in Salman (here) nor the Seventh Circuits pre-Newman decision in Maio support the Government’s contention. The former was built on a close personal relationship between the insider and the outsider where there was direct evidence that the tip was intended as a gift of market-sensitive information (here). In addition, the Government argued that the evidence was sufficient to meet the Dirks rule as articulated by Newman. While the Ninth Circuit did state that if Newman were read to require that the benefit be tangible it would not go that far, neither did the Second Circuit. To the contrary, Newman held that “’personal benefit is broadly defined to include not only pecuniary gain, but also . . . the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend,” quoting Newman.
Likewise, Mio was built on a fact pattern evidencing a long standing, close personal relationship Indeed, the record demonstrated that the tipping “was just one of many favors that . . . [the tipper had] done form . . .[the tippee] through the years by reason of their friendship,’” quoting Mio.
Finally, Respondent contends that this case is “a poor vehicle” to review this question and would “not benefit” the markets. The former is true because the Second Circuit rendered two holdings on the element of knowledge. One was that the district court failed to give the appropriate jury instruction while the second was the lack of evidence. The second alone is sufficient to support the Second Circuit’s judgment. The latter arises because accepting this case for review would create uncertainty in the markets regarding Dirks which would not be beneficial, according to Respondents.
Respondents and the Government both claim that their position is solidly grounded on Dirks. While the parties appear to have diametrically opposite position, both may in fact be correct. Both quote extensively from the Supreme Court’s decision. There is little doubt that Dirks fashioned the personal benefit test in an effort to draw a bright line between lawful actions and illegal tipping. The real question here seems to be precisely what must be established to meet the personal benefit test. Dirks did not write detailed rules specifying what evidence must be presented. Newman, following Dirks took the same approach, although it does stress the necessity for a something more than just casual friendships the Government and the SEC sometimes cite.
The difference between the two sides is also reflected in their vastly different views of the record. The Government’s brief contains an extensive review of the record, detailing evidence which if correct seems to be sufficient to meet the Newman test. In contrast the evidence detailed in the Respondents’ brief appears to track much closer to the summary presented by the Court in Newman. There, of course, the Court found that the evidence was completely insufficient.
To the extent that this case turns on quantifying the amount of evidence required to meet the personal benefit – a point highlighted by Respondent’s focus on the word “exchange” — it seems unlikely that the High Court would accept it for review. Similarly, if the resolution of the case hinges on a detailed analysis of the record, again, consideration by the Supreme Court would seem unlikely. The High Court is most unlikely to weigh in on a case where it would be required to wade through the record and analyze the evidence. No doubt that is the reason Respondent phased the question for resolution as one of evidence.
In contrast, if the Court reads Newman as obliterating the clear line Dirks attempted to draw resulting in unnecessary risk for analysts and others while creating uncertainty in the markets and undue difficulty for law enforcement, the Court may consider the question. A decision on whether the Court will hear the case should be announced early this Fall.
The Sixth Circuit last week concluded that Morrison, which held that Section 10(b) does not have extraterritorial reach, is inapplicable to Advisers Act Section 10(b). The DC Circuit, on rehearing, reaffirmed its prior holding that a portion of the Commission’s Dodd-Frank conflict rules violates the First Amendment.
SEC enforcement prevailed on a summary judgment motion in an action centered on false statements made by an issuer regarding a claimed cancer treatment. In addition, two new offering fraud actions were filed along with an insider trading case and another action centered on the misappropriation of funds in connection with an EB-5 program.
Statement: Commissioner Luis A. Aguilar issued a statement titled Enhancing the Commission’s Waiver Process (August 27, 2015). The statement calls for more transparency in the waiver process and a flexible approach while discussing a process adopted last year regarding conditional waivers (here).
SEC Enforcement — Litigated cases
False statements: SEC v. Cook, Civil Action No. 1:13-cv-01312 (S.D. Ind.) is an action against Timothy Cook, Xytos, Inc. and Asia Equities. The complaint alleged that beginning in 2010 Mr. Cook made materially misleading statements regarding the company, supposedly in the biomedical business, and a claimed cancer treatment. The SEC also alleged that he sold unregistered shares in the firm. In fact there was no treatment. The court granted summary judgment in favor of the Commission, concluding that Mr. Cook violated Securities Act Sections 5(a) and 5(c) and 17(a) and Exchange Act Section 10(b). The court imposed a permanent injunction, an officer and director bar, a penny stock bar and ordered disgorgement in the amount of $642,828. The Court will consider the amount of a civil penalty. Default judgments were entered against the two entities. See Lit Rel. No. 23328 (August 25, 2015).
SEC Enforcement – Filed and Settled Actions
Statistics: During this period the SEC filed 3 civil injunctive cases and 1 administrative actions, excluding 12j and tag-along proceedings.
Offering fraud: SEC v. Schumacher, Civil Action No. 15-6388 (C.D. Cal. Unsealed August 26, 2015) is an action which names as defendants Harrison Schumacher and his two firms, Quantum Energy LLC and Quaneco LLC. Since 2010 the defendants have raised $12.3 million through a series of five offerings from over 300 investors. Those investors were told the funds would be used to explore for and develop oil and gas properties. Instead they were diverted to other uses by the defendants. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b) and 15(a). The case is pending. See Lit. Rel. No. 15-6388 (August 27, 2015).
Insider trading: SEC v. Aggarwal, Civil Action No. 2:15-cv-06460 (C.D. Cal. Filed August 25, 2015). Defendant Ashish Aggarwal worked as an analyst at J.P. Morgan Securities LLC in its San Francisco office. His friend, defendant Shahriyar Bolandian, worked for an e-commerce company founded by Kevan Sadigh, also a defendant in the SEC’s action. Each defendant declined to testify during the staff’s investigation. The case involved trading in two deals. The first involved Integrated Device Technology, Inc. and PLX Technology, Inc. The second involved the ExactTarget, Inc., a provider of email and cloud marketing services, and salesforce.com, Inc., a provider of enterprise cloud computing services. Following the retention of JPM in each instances there were multiple text messages between Messrs. Aggarwal and Bolandian and multiple trades by Mr. Bolandian and Mr. Sadigh. After the first deal announcement Messrs. Bolandian and Sadigh sold their interest in PLXT, yielding, respectively, gains of $36,200 and $41,200. After the second Mr. Bolandian’s accounts had profits of about $317,000. Mr. Sadigh had profits of about $178,000. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is pending. See Lit. Rel. No. 23327 (August 25, 2015).
Offering fraud: In the Matter of Randy E. Olshen, Adm. Proc. File No. 3-16549 (August 25, 2015) is a proceeding naming as a Respondent Mr. Olshen, the founder and President of Innovative Health Solutions, LLC, a sports hydration drinks company. Beginning in 2009 Mr. Olshen is alleged to have implemented a plan to sell unregistered shares in the company using fabricated accounting records. Over $7 million was raised from about 50 investors. The Order alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). To resolve the matter Mr. Olshen consented to the entry of a cease and desist order based on the Sections cited in the complaint. In addition, an order was entered barring him from the securities business and from participating in any penny stock offering. In view of the requirement that he pay restitution in the related criminal matter in which he pleaded guilty, no restitution or penalty was ordered.
Misappropriation: SEC v. Path America, LLC, Civil Action No. 2:15-cv-01350 (W.D. Wash. Filed August 24, 2015). Named as defendants in this action are Lobsang Dargey and seven LLCs he controls including Path America, LLC, Path America SnoCo, LLC and five other similarly named entities. Mr. Dargey also controls the bank account for each entity through with the program funds flowed. The action centers around two projects, the Tower Project and the Farmer’s Market Project. For the Tower Project, beginning in November 2013 Mr. Dargey, Path America and three other controlled entities raised about $85 million from 170 Chinese nationals as investments in real estate developments in Seattle. Investors acquired a limited partnership interest for $500,000 plus an administrative fee of $45,000.For the Farmer’s Market project, beginning in 2012 Mr. Dargey, Path America and other related entities raised about $41 million from 82 Chinese nationals as investments in a residential real estate development in Everett, Washington. The PPM was substantially similar to the one for the Tower Project. Both PPMs were false and misleading, according to the complaint. Both represented that the funds would only be used in accord with the business plans provided to USCIS. In fact they were not. Overall defendants are alleged to have misappropriated about $17.6 million of investor funds. The complaint alleges violations of Exchange Act Section 10(b) and each subsection of Securities Act Section 17(a). The Commission secured an emergency freeze order. The case is pending. See Lit. Rel. No. 23326 (August 25, 2015).
Net capital: The regulator fined Charles Schwab & Co. $2 million and censured the firm in connection with net capital violations between May 15, 2014 and July 1, 2014. The violations arose because on certain dates the inflows of cash to the firm exceeded the amounts it could invest so it made large, unsecured loans to its parent resulting in net capital violations. In doing that the firm failed to consult with its regulatory group, demonstrating a lack of procedures.
Court of Appeals
Extraterritorial reach: Lay v. U.S., Case No. 13-4021 (6th Cir. August 17, 2015). Defendant Mark Lay was a registered investment adviser. He operated two funds, one on shore and the other off shore, in which he invested funds for the Ohio Bureau of Workers’ Compensation. The off-shore fund suffered losses after he leveraged it, contrary to the rules of the Bureau. Although he concealed the losses and the leverage eventually the Bureau found out and withdrew its funds. Only $9 million of its $225 million investment was returned. Mr. Lay was convicted of securities fraud and other charges. He argued, however, that the securities fraud conviction, based on Advisers Act Section 206, was barred by Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010). There the Court held that Exchange Act Section 10(b) did not have extraterritorial reach based on a presumption against such reach absent Congressional intent to the contrary. The Court rejected this contention, concluding that “The problem with defendant’s argument is two-fold: (1) the Securities Exchange Act and the Investment Advisers Act seek to regulate different aspects of securities transactions, and (2) unlike Morrison, the only aspect of this case not tied to the United States is that the fund in question is based in Bermuda. All other aspects of the case are centered in the United States.” In addition, the focus of the Advisers Act is the prevention of wrongful practices by the adviser, the Court determined. This contrasts sharply with the Exchange Act which is centered on the purchase or sale of a security. According, the court concluded that Morrison does not apply to Section 206 of the Advisers Act.
Conflict mineral rule: National Association of Manufactures v. SEC, No. 13-5252 (D.C. Cir. Opinion issued August 18, 2015). This suit challenged the SEC’s conflict minerals rules, written under Dodd-Frank. The initial decision upheld the rules but rejected one provision as contrary to the First Amendment (here). On rehearing by the panel, the result was the same. The rehearing was granted because the en banc court, in another case, reinterpreted the Supreme Court’s decision in Zander v. Office of Disciplinary Counsel of the Supreme Court of Ohio, 471 U.S. 626 (1985) which governed the standard of review in compelled speech cases regarding misleading advertising and broadened it to include labeling for country of origin for meat cuts. That standard is more relaxed than the one applied in the prior decision based on Central Hudson Gas & Electric Corp. v. Public Service Commission, 447 U.S. 557 (1980). Nevertheless, the court refused to apply Zander.
To bolster its decision, the Court added an alternate holding keyed to three points. First, under Central Hudson the court must assess the interest motivating the disclosure requirement. The SEC noted that it is ameliorating the humanitarian crisis in the DRC. This is sufficient. Second, the effectiveness of the measure in achieving that goal must be assessed. The SEC offered little on this point the Court noted. A review of various materials, including the potential costs, lead the Court to conclude that there was little but speculation. “[T]his presents a serious problem for the SEC because . . . the government must not rest on such speculation or conjecture . . . Rather the SEC had the burden of demonstrating that the measure it adopted would ‘in fact alleviate’ the harms it recited . ..” “This in itself dooms the statute and the SEC’s regulations” the Court concluded.
Finally, the Court considered if the compelled disclosures were “purely factual and uncontroversial.” The descriptions of “conflict free” or “not conflict free” are hardly factual and non-ideological. This requires an issuer to tell consumers if its goods are ethically tainted.” “By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.”
The EB-5 program is supposed to provide a path to a permanent green card. The program was designed to create that path for foreign national who invest specified sums in the U.S. that create jobs – a win win for everyone. Unfortunately, in some instances there is no win. The SEC has brought a number of cases alleging fraud and other violations of the securities laws in connection with the program. The agency’s most recent case in this area centers on allegations that a promoter diverted substantial portions of the money to himself that were intended for development and job creation under the program. SEC v. Path America, LLC, Civil Action No. 2:15-cv-01350 (W.D. Wash. Filed August 24, 2015).
Named as defendants in this action are Lobsang Dargey and seven LLCs he controls including path America, LLC, Path America SnoCo, LLC and five other similarly named entities. Mr. Dargey also controls the bank account for each entity through with the program funds flowed.
The action centers around two projects. One is the Tower Project. The other is the Farmer’s Market Project. First, regarding the Tower Project, beginning in November 2013 Mr. Dargey, Path America and three other controlled entities raised about $85 million from 170 Chinese nationals as investments in real estate developments in Seattle. Investors acquired limited partnership interest for $500,000 plus an administrative fee of $45,000. The investment was to be wired to an escrow account in the U.S. The administrative fees was to be wired to an account in Hong Kong. The PPM stated that the goal was to raise $122 million from 244 investors and that the program was intended to qualify for the EB-5 program.
The PPM and subscription agreement also provided that on confirmation the investor had filed an EB-5 visa petition with the USCIS, $400,000 would be released from escrow. The remaining $100,000 would be released on confirmation that USCIS had approved the investor’s EB-5 visa petition.
Second, for the Farmer’s Market project, beginning in 2012 Mr. Dargey, Path America and other related entities raised about $41 million from 82 Chinese nationals as investments in residential real estate development in Everett, Washington. The PPM was substantially similar to the one for the Tower Project.
Both PPMs were false and misleading, according to the complaint. Both represented that the funds would only be used in accord with the business plans provided to USCIS. In fact they were not. The defendants are alleged to have misappropriated substantial sums from the two projects. For example, on September 9, 2014 Mr. Dargey transferred $1.5 million from the Tower Project Account to an account for Dargey Development LLC. The next day the funds were moved to an account for Mr. and Mrs. Dargey. A few days later funds from that account were used to purchase a residential property in the name of a trust whose beneficiaries are the couple. Other similar transfers were made. Overall defendants are alleged to have misappropriated about $17.6 million of investor funds.
The complaint alleges violations of Exchange Act Section 10(b) and each subsection of Securities Act Section 17(a). The Commission secured an emergency freeze order. The case is pending. See Lit. Rel. No. 23326 (August 25, 2015).
The SEC and the Department of Justice announced insider trading charges against a former investment banker and his long time friend centered on two deals. The SEC’s complaint also named a third person alleged to have been a second tier tippee. SEC v. Aggarwal, Civil Action No. 2:15-cv-06460 (C.D. Cal. Filed August 25, 2015).
Defendant Ashish Aggarwal worked as an analyst at J.P. Morgan Securities LLC in its San Francisco office. His friend, defendant Shahriyar Bolandian, worked for an e-commerce company founded by Kevan Sadigh, also a defendant in the SEC’s action. Each defendant declined to testify during the staff’s investigation.
Mr. Aggarwal was an analyst in the JPM investment banking department in the Technology, Media & Telecommunications Group. He routinely had access to inside information from his employment. He had a duty to preserve the confidentiality of that information under the firm’s Code of Conduct.
Messrs. Aggarwal and Bolandian had been close friends since they were undergraduate students at Berkley. Beginning at least in 2012 Mr. Bolandian, in consultation with his friend, conducted a series of securities trades in one or more accounts. Trading in this fashion permitted Mr. Aggarwal to circumvent the JPM pre-clearance rules regarding securities trading and potentially share in the profits. By March 2013 however the two men suffered trading losses.
The first deal involved Integrated Device Technology, Inc. and PLX Technology, Inc. In early 2012 JPM was retained by Integrated Device, a provider of integrated circuits, with respect to the acquisition of PLX, a provider of integrated circuits that performed system connectivity functions. By mid-April the negotiations advanced. By April 15 a draft merger agreement had been prepared. At some point prior to the end of that month Mr. Aggarwal learned about the deal. He had access to information about it through a friend, Analyst 1.
On April 16, 2012 Mr. Bolandian bought 200 shares of PLXT stock and 30 call options. He and his friend, Mr. Aggarwal, had previously exchanged multiple text messages and spoke on the telephone. That same day Mr. Sadigh purchased 500 shares of PLXT stock and 30 call options. The pattern of purchases and text messages continued until the deal announcement after the close of the markets on April 30, 2012. Following the announcement the share price increased 97%. In May Messrs. Bolandian and Sadigh sold their interest in PLXT, yielding, respectively, gains of $36,200 and $41, 200.
The second deal involved the ExactTarget, Inc., a provider of email and cloud marketing services, and salesforce.com, Inc., a provider of enterprise cloud computing services. In May 2013 ExactTarget retained JPM in connection with a possible merger. The JPM deal team included Analyst 2 and Analyst 3, both of whom were friends of Mr. Aggarwal. As with the PLX deal, Messrs. Aggarwal and Bolandian exchanged a number of text messages following the retention of JPM by ExactTarget. On May 8, 2013 Mr. Sadigh made his first purchase of ExactTarget securiites. Mr. Bolandian wired additional cash to his brokerage account the same day. The next day he purchased 60 call options in ExactTarget. Mr. Sadigh bought 50 call options that day. The complaint details multiple text messages and trading by the two men prior to the deal announcement on June 4, 2013 before the opening of the market. Following the announcement the share price increased by 50%. Mr. Bolandian’s accounts had profits of about $317,000. Mr. Sadigh had profits of about $178,000.
The complaint alleges that Messrs. Aggarwal, Bolandian and Sadigh breached their duties to maintain the information in confidence. It also alleges that Messrs. Bolandian and Sadigh knew or were reckless in not knowing that they were trading on inside information. Mr. Aggarwal furnished the information to his friend in exchange for “personal benefits, direct or indirect, that were previously provided, were provided on an ongoing basis, or were to be provided in the future . . .” Those benefits included the satisfaction of making gifts to a close friend, having Mr. Bolandian hold and trade securities for him and, “on information and belief Aggarwal’s ability to share in the profits and recoup losses from securities trades in Bolandian’s account(s).” The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is pending. See Lit. Rel. No. 23327 (August 25, 2015).
The SEC’s conflict mineral disclosure rule, enacted under Dodd-Frank, is a continuing source of controversy. An initial challenge to the rules was brought by the National Association of Manufactures. That challenge was largely rejected by the district court and the D.C. Circuit. One provision, however, was held to contravene the First Amendment — a disclosure requirement that the products be labeled DRC Free with a corresponding statement on the firm website. National Association of Manufactures v. SEC, No. 13-5252 (D.C. Circ. 2014)(here).
On rehearing the result was the same. National Association of Manufactures v. SEC, No. 13-5252 (D.C. Cir. Opinion issued August 18, 2015). In the initial decision much of the controversy revolved around the standard of scrutiny that would be applied to the disclosure requirement. There the Court applied the teachings of Zander v. Office of Disciplinary Counsel of the Supreme Court of Ohio, 471 U.S. 626 (1985). While the circuit courts are split on the meaning of this decision, the D.C. Circuit has conclude that it is “limited to compelled speech designed to cure misleading advertising. Other government regulations compelling commercial speech are evaluated under Central Hudson Gas & Electric Corp. v. Public Service Commission, 447 U.S. 557 (1980). Zander utilizes a more relaxed standard than Hudson Gas.
In its earlier ruling the Court concluded that Zander was inapplicable because it was limited to situations where the disclosures were being compelled to cure what would otherwise be misleading advertising. That is not the case with the SEC’s conflict mineral rules.
Following the initial decision, however, the Court, sitting en banc, decided American Meat Institute v. U.S. Department of Agriculture, 760 F. 3d 18 (D.C. Cir. 2014)(en banc). There the Court concluded that Zander applies to “more than a state’s forcing disclosures in order to cure what would otherwise be misleading advertisements . . . Some other governmental interests might suffice.” In AMI the Court applied the Zander standard in concluding that the government had not violated the First Amendment by forcing companies to list country of origin information on meat cuts. This decision overruled part of the Circuit’s jurisprudence regarding Zander. In view of AMI the Court granted rehearing.
The conflict mineral rules do not deal with advertising or point of sale disclosures. Rather, they were directed at achieving “overall social benefits.” The Supreme Court has refused to apply Zander to cases not involving voluntary commercial advertising. Accordingly, the Court refused to apply it here. This puts the case in the same posture as the first time it was before the Court. Then the Court concluded that the final rule “does not survive even Central Hudson’s intermediate standard.” That holding still applies.
To bolster its decision, the Court added an alternate holding keyed to three points. First, under Central Hudson the court must assess the interest motivating the disclosure requirement. The SEC noted that it is ameliorating the humanitarian crisis in the DRC. This is sufficient under AMI and Central Hudson.
Second, the effectiveness of the measure in achieving that goal must be assessed. The SEC offered little on this point the Court noted. A review of various materials, including the potential costs, lead the Court to conclude that there was little but speculation. “[T]his presents a serious problem for the SEC because . . . the government must not rest on such speculation or conjecture . . . Rather the SEC had the burden of demonstrating that the measure it adopted would ‘in fact alleviate’ the harms it recited . ..” “This in itself dooms the statute and the SEC’s regulations” the Court concluded.
Finally, the Court considered if the compelled disclosures were “purely factual and uncontroversial.” The descriptions of “conflict free” or “not conflict free” are hardly factual and non-ideological. This requires an issuer to tell consumers if its goods are ethically tainted.” “By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.”
In Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010) the Supreme Court held that the reach of Exchange Act Section 10(b) is the water’s edge of the United States. Specifically, the court held that the Section only provides a cause of action if the purchase or sale of the security took place on a U.S. exchange or within the United States. The decision is based on a presumption that legislation has no extraterritorial reach absent an express Congressional intent to the contrary. Since the Exchange Act lacks any such expression Section 10(b)’s reach is limited by its focus – the location of the purchase or sale of the security.
Subsequently, Morrison has been followed in a series of Section 10(b) actions. The Second Circuit has also applied its teachings to RICO and the Commodity Exchange Act. In contrast, the Sixth Circuit, concluded that Morrison does not apply to another securities statute – Section 206 of the Investment Advisers Act. Lay v. U.S., Case No. 13-4021 (6th Cir. August 17, 2015).
Defendant Mark Lay was convicted of investment adviser fraud and on counts of wire fraud related to investments he made for the Ohio Bureau of Workers’ Compensation. Mr. Lay found MDL Capital Management, Inc. The firm became an SEC registered investment adviser.
One of the firm’s clients was the Ohio Bureau of Workers’ Compensation. That agency assists Ohio based employers and employees with expenses tied to work place injuries. For years Mr. Lay and his firm managed the Bureau’s funds in a U.S. based fund. Investments were primarily in U.S. long term treasury bonds. The fund made money.
Subsequently, Mr. Lay founded an “offshore” hedge fund in Bermuda. MDL Capital was its adviser, although there was no specific advisory agreement between the Bermuda fund and MDL. The investments of the Bureau were managed in both funds.
At one point Mr. Lay and MDL began leveraging the Bermuda fund. This was contrary to the agreement with the Bureau who was not informed. Losses were incurred. Rather than inform the fund, Mr. Lay and MDL sought permission to use leverage. It was denied. Eventually the Bureau learned of the leverage and the concealed losses. The agency withdrew its funds. Only $9 million of its $225 million investment was returned.
The District Court rejected Mr. Lay’s claim that Morrison compelled dismissal of the Section 206 charge. The Circuit Court agreed: “The problem with defendant’s argument is two-fold: (1) the Securities Exchange Act and the Investment Advisers Act seek to regulate different aspects of securities transactions, and (2) unlike Morrison, the only aspect of this case not tied to the United States is that the fund in question is based in Bermuda. All other aspects of the case are centered in the United States.”
The Advisers Act regulates person and entities who advise others on securities investments. Those persons register with the SEC and have fiduciary duties to their clients. Those include good faith, loyalty and fair dealing, the Court noted. In contrast, the Exchange Act does not specifically “prescribe a stand of conduct for investment advisers.” In addition, here virtually all of the conduct is domestic, unlike Morrison.
Finally, the focus of the Advisers Act is the prevention of wrongful practices by the adviser, the Court determined. This contrasts sharply with the Exchange Act which is centered on the purchase or sale of a security. According, the court concluded that Morrison does not apply to Section 206 of the Advisers Act.
The Commission filed a settled FCPA action this week centered on hiring relatives of foreign officials tied to a sovereign wealth fund. In addition, the agency filed two actions involving Citigroup – one based on the market crisis and a second tied to compliance failures – a boiler room case, two offering fraud actions and three based on the miscalculation of AUM at one firm.
SEC Enforcement – Filed and Settled Actions
Statistics: During this period the SEC filed 2 civil injunctive cases and 7 administrative actions, excluding 12j and tag-along proceedings.
Boiler room: SEC v. Moshe Dunoff, Civil Action No. 2:15-cv-04732 (E.D. Pa. Filed August 20, 2015) is an action centered on a boiler room that was in operation over a two year period beginning in January 2009. Individuals located in Southeast Asia made unsolicited telephone calls to investors proposing a no-loss investment strategy. According to the proposal, investors could purchase common stock of public companies at a substantial discount. Later Chicago broker Gruber and Green would arrange for the sale of the shares at increased prices to institutional investors. The scheme raised about $1.5 million from 58 investors in 14 countries. Investor funds were deposited in six accounts opened by Mr. Dunoff at banks in Pennsylvania and Florida in the names of two fictitious companies. In fact, no stock was purchased and the claimed Chicago broker does not exist, according to the complaint. Mr. Dunoff retained part of the investor funds for himself and wired the remainder to accounts in the Philippines, Thailand and Indonesia controlled by others. The complaint alleges violations of Securities Act Sections 17(a)(1) and (3) and Exchange Act Section 10(b) and Rule 10b-5(a) and (c). The case is pending. See Lit. Rel. No. 23325 (August 20, 2015).
Compliance: In the Matter of Citigroup Global Markets, Inc., Adm. Proc. File No. 3-16764 (August 19, 2015) is a proceeding centered on compliance and surveillance failures at the firm that in some instances went undetected for years. Over a period of about ten years beginning in 2002 the firm’s monitoring of its trading was inadequate because it did not track thousands of transactions executed by several trading platforms or electronic systems. The firm also inadvertently routed 467,000 transactions on behalf of advisory clients to an affiliated market maker, Automated Trading Desk Financial Services LLC, which executed the transactions as principal at or near prevailing market prices. The violations resulted from failing to have adequate procedures. The Order alleges violations of Exchange Act Section 15(g). In assessing the remedies, the Commission took into account the firm’s prior regulatory violations. Respondent will implement a series of undertakings, including the retention of a consultant. The firm consented to the entry of a cease and desist order based on the Section cited in the Order and to a censure. In addition, it will pay a $15 million penalty.
Market crisis: In the Matter of Citigroup Alternative Investments LLC, Adm. Proc. File No. 3-16757 (August 17, 2015). Respondent Citigroup Alternative is a subsidiary of Citigroup Inc. It was the investment manager for the ASTA/MAT and Falcon funds. Respondent Citigroup Global Markets Inc., is an affiliate of Citigroup Inc. It recommended and sold share of ASTA/MAT, a leveraged municipal arbitrage fund, and Falcon fund, a multi-strategy fund invested in fixed income strategies and asset-backed securities which was also leveraged, to investors associated with it. From September 2002 through early 2007 Respondents offered and sold about $1.9 billion of investments in ASTA/MAT to about 2,700 investors and advisory clients of Citigroup Global. From late 2004 through October 2007 Respondents sold about $936 million of investments in Falcon to about 1,300 investors and advisory clients of Citigroup Global. In marketing the funds investors were told of their safety but not the actual risks. As the market crisis moved forward, and their condition deteriorated, shares continued to be sold without disclosing the then current financial condition or the true risks. The Order alleges violations of Securities Act Sections 17(a)(2) and (3) and Advisers Act Sections 206(2) and 206(4). To resolve the action Respondents consented to the entry of cease and desist orders based on the Sections cited in the Order as well as censures. In addition, they will pay disgorgement of $139,950,239 along with prejudgment interest.
False AUM: In the Matter of Bradford D. Szezecinski, Adm. Proc. File No. 3-16760 (August 17, 2015); In the Matter of Tamara S. Kraus, Adm. Proc. File No. 3-16759 (August 17, 2015); In the Matter of Theodore R. Augustyniak, Adm. Proc. File No. 3-16758 (August 17, 2015). These proceedings arise out of the failure of Ariston Wealth Management, L.P., formerly a registered investment adviser, to properly state its AUM in filings. Specifically, in March of 2012 those files stated AUM was $190 million when in fact it was less than $80 million. In addition, the firm did not adopt policies and procedures as required by the Advisers Act prior to an October 2012 OCIE inspection. Mr. Szczecinski was the president, Ms. Kraus the Chief Compliance Officer and Mr. Augustyniak a vice president of the adviser. The Order as to Mr. Szececiniski alleged violations of Advisers Act Sections 206(4) and 207. He resolved the proceeding by agreeing to implement certain undertakings and consenting to the entry of a cease and desist order based on the Sections cited in the Order. In addition, he will pay a penalty of $25,000. The Order as to Ms. Kraus alleged violations of Advisers Act Sections 203A and 207. To resolve the proceeding she consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, she will pay a penalty of $10,000 and will implement certain undertakings. The Order as to Mr. Augustyniak alleged violations of Advisers Act Section 207. To resolve the matter he agreed to certain undertakings and consented to the entry of a cease and desist order based on the Section cited in the Order. In addition, he will pay a penalty of $10,000.
Offering fraud: SEC v. EnviraTrends, Inc., Civil Action No. 8:15cv1903T27 (M.D. Fla. Filed August 17, 2015). Defendant EnviraTrends is a development stage firm that claimed to be in the business of selling memorial products for pets, scooters and involved in exports to China. Defendant Russell Haraburda is the founder of EnviraTrends and served as its CEO, President and Director. He controlled the company. Over a three year period beginning in mid-2009 the defendants raised over $2.3 million through the sale of EnviraTrends shares to over 100 investors in thirteen states. Defendants made a series of false statement in connection with those sales which concerned its business plan and operation, going public, the use of investor funds and the performance of the company. In February 2012 the firm filed a Form 8-A/12G with the SEC, registering its shares under Section 12(g) of the Exchange Act. Thereafter the firm was required to make Section 13(a) filings. It failed to make the required filings and its stock was deregistered. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b), 13(a) and 15(d)(1). Each defendant consented to the entry of a permanent injunction based on the Sections cited in the complaint. In addition, the defendants will, on a joint and several basis, pay disgorgement and prejudgment interest of over $2.3 million. Payment of all but $150,000 was waived based on financial condition. Mr. Haraburda was also barred from serving as an officer or director of a public company and participating in any penny stock offering. See Lit. Rel. No. 23321 (August 17, 2015).
Offering fraud: In the Matter of Success Trade, Inc., Adm. Proc. File No. 3-16755 (August 14, 2015). Respondent Success Trade is the Washington, D.C. based parent of registered broker dealer Success Trade Securities, Inc., also a Respondent, and BP Trade, Inc., a software company. Both are operated by Fuad Ahmed, as is BP Trade. Success Trade Securities operated as a deep discount broker. The firm never generated sufficient cash flow to be successful. After borrowing working capital at rates of 50-53% the firm sought to raise additional capital by marketing notes. The PPM had a schedule of how the funds would be used for the business. Instead they were diverted to other matters.
By November 2012 Respondents were again facing severe financial pressure. Success Trade did not have cash flow to cover its obligations. Accordingly, Respondents persuaded a number of note holders to either extend the notes or convert their investment to equity, typically offering higher interest rates or lower conversion prices than were authorized by the PPM. In connection with those efforts, note holders were not told the true financial condition of the firm and were provided inaccurate information. The note offering was not registered or exempt from registration because many of the investors were both non-accredited and unsophisticated. The Order alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). Respondents resolved the action, consenting to the entry of a cease and desist order based on the Sections cited in the Order. They also agreed to pay, on a joint and several basis, disgorgement of $12,777,395.80 and prejudgment interest. Respondents will, in addition, pay on a jointly and severally, a penalty of $12,777,395.80. Additional proceedings will be held to determine if a bar order as to Mr. Ahmed is appropriate.
In the Matter of The Bank of New York Mellon Corporation, Adm. Proc. File No. 3-16762 (August 18, 2015). Respondent BNY Mellon is a global financial services firm which at times operates through subsidiaries and affiliates. One unit is BNYM Asset Servicing. Another is wholly owned BNY Mellon Boutique, an asset management firm.
Middle Eastern Sovereign Wealth Fund became a client of BNYM Asset Servicing in 2000. The services were largely custodial. Two years later Asset Servicing entered into an arrangement with the Wealth Fund under which the assets could be loaned out in accord with certain guidelines. In 2009 the Wealth Fund became a client of Asset Management, designating the Boutique to manage about $711 million in assets. Under the terms of the agreement the assets under management could be increased.
Officials X and Y, both senior officials connected to the Wealth Fund, began seeking internships for relatives in 2010. At the time BNY Mellon had established summer internship programs with specific criteria and procedures for securing a position. Eventually three relatives of the officials were given internships without following the usual procedures. BNY Mellon retained the Boutique mandate and further assets were transferred by Official X’s department within a few months. BNY Mellon retained its existing custody and securities lending business which continued to grow.
BHY Mellon had a code of conduct and a specific FCPA policy. During the time period, however, BNY Mellon “had few specific controls relating to the hiring of customers and relatives of customers, including foreign government officials,” according to the Order. Here the senior managers were able to approve the hiring of the interns without any review by persons with legal or compliance backgrounds. Accordingly, the Order notes, the system of internal accounting controls were deficient.
The Order alleges violations of Exchange Act Section 30A and Section 13(b)(2)(B). The Commission acknowledged the cooperation of BNY Mellon and its remedial acts which, prior to the SEC’s investigation, included initiating reforms to its anti-corruption policy to address the hiring of government officials’ relatives.
To resolve the case Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, BNY Mellon agreed to pay disgorgement of $8.3 million, prejudgment interest and a civil money penalty of $5 million. BNY Mellon acknowledged that a penalty of over $5 million was not imposed based on its cooperation.
Report: The Board published its Annual Report on Inspections of Broker and Dealer Auditors. It continued to record a high level of independence findings and audit deficiencies (here).