This Week In Securities Litigation (Week ending Dec. 7, 2018)

The Supreme Court was the focus this week with oral argument in Lorenzo v. SEC, an action centered on ascertaining the dividing line between primary and secondary liability under Exchange Act section 10(b). The arguments were based on the application of two prior decisions of the Court, Janus regarding liability for false statements under Rule 10b-5(b) and Central Bank of Denver which held that if the conduct falls within the language of section 10(b) there is a primary violation of the statute.

The Commission filed enforcement actions this week based on insider trading and business development entities. The former centered on an the misappropriation of inside information by a foreign national at a Singapore entity. The latter two cases were based on the mischaracterization of distributions and a failure properly allocate expenses.

Supreme Court

The Supreme Court heard argument on the question frequently referred to in the circuit and district courts as scheme liability on Monday, December 3, 2018. Lorenzo v. SEC, No. 17-1077. Specifically, the question as framed by Petitioner Francis Lorenzo is “whether the D.C. Circuit erred in concluding a misstatement claim that does not meet the elements set forth in Janus [Janus Capital Group, Inc., v. First Derivative Traders, 564 U.S. 135 (2011)] can be repackaged and pursued as a fraudulent scheme claim under Section 10(b) of the Exchange Act . . . and Section 17(a)(1) of the Securities Act.” The D. C. Circuit and the Securities and Exchange Commission rejected the contention.

Frank Lorenzo was a director at investment bank Charles Vista, LLC in February 2009. The firm’s largest investment banking client was start-up W2Energy Holdings, Inc. Its business depended largely on the success of certain technology which failed. The firm attempted to raise about $15 million through the sale of convertible debentures with the assistance of Charles Vista. Mr. Lorenzo emailed two potential investors “several key point” about W2E’s pending debenture offering at the behest of his boss who settled. The emails failed to mention the recent devaluation of the firm’s assets.

Petitioner Lorenzo relied on Janus for the proposition that “only the maker of a misstatement can be held liable for that misstatement under Section 10(b) and Rule 10b-5.” While the lower court agreed that is the law under Janus, and that Mr. Lorenzo was not the “maker” of the statements, it found him liable. To reach that conclusion the D.C. Circuit concluded that Mr. Lorenzo “engaged in a deceptive act, artifice to defraud, or practice, for purposes of liability under Section 10(b) . . .” That was error since it directly undercuts the holding of Janus Petitioner argued.

Counsel for the Government focused first on the facts and then the holding of Central Bank. “Petitioner’s decision to send emails that grossly misrepresented the financial prospects of his client and to give illusory promises designed to deceive investors into backing a business that he knew was failing constitute a quintessential securities fraud. His conduct falls within the plain text and the common-sense meaning of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and subsections (a) and (c) of Rule 10b-5.” Since Central Bank held that if the conduct fell within the language of the statute, as here, there is primary liability counsel for the Government claimed.

SEC Enforcement – Filed and Settled Actions

Statistics: Last week the SEC filed 2 civil injunctive case and 2 administrative proceedings, excluding 12j and tag-along proceedings.

Insider trading: SEC v. Gannamaneni, Civil Action No. 18 CV 11390 (S.D.N.Y. Filed Dec. 6, 2018) is an action which names as a defendants Rajeshwar Gannamaneni, a citizen of India, his wife, Deepthi Gandra, and his father, Linga Gannameneni. Mr. Gannameneni was the information technology contractor at a prominent investment bank in Singapore. Over a period of about three years, beginning in late 2013, Mr. Gannameneni misappropriated inside information about 40 times and used it to trade while sharing it with his wife and father. About $600,000 in illicit profits resulted. The complaint alleges violations of Exchange Act sections 10(b) and 14(e). The case is pending.

Fraudulent trading: SEC v. Litvak, No. 313-CV-00132 (D. against Conn.) is a previously filed action against Jefferies & Co. Inc. trader Jesse Litvak. In a parallel criminal action Mr. Litvak was twice convicted. The convictions were reversed by the Second Circuit Court of Appeals in each instance. In August the U.S. Attorney’s Office dismissed the charges against Mr. Litvak. The Commission also elected to dismiss its compliant. See Lit. Rel. No. 24368 (Dec. 6, 2018).

Misappropriation: SEC v. Rothenberg, Civil Action No. 3:18-cv-05080 ((N.D. Cal.) is a previously filed action in which the Commission alleged that investment adviser defendant Michael Rothenberg misappropriated about $7 million from his clients, in part by overcharging them, to fund his other business ventures. The complaint alleged violations of Advisers Act sections 206(1) and 206(4). Defendant has agreed to resolve the charges. The settlement included a bar from the brokerage and investment advisory business with the right to reapply after 5 years. The court will determine the amount of the disgorgement. See Lit. Rel. No. 24367 (Dec. 6, 2018).

Misappropriation –EB5: SEC v. Chen, Civil Action No. 2:17-cv-06929 (C.D.C.A.) is a previously filed action which named as defendants Edward and Jean Chen, a husband and wife who promoted an EB-5 project. The complaint alleged that they raised about $22.5 million from 45 investors in China for the development of an EB-5 project. More than $12 million was misappropriated. Defendants settled with the Commission. The Court entered a final judgment resolving all claims which enjoins the defendants from violating Exchange Act section 10(b) and Securities Act section 17(a) as well as from participating in the offer and sale of any security which constitutes an investment in a commercial enterprise under the USCIS EB-5 visa program. The order also directs the disgorgement, on a joint and several basis, of $24,655,000 along with prejudgment interest of $1,273,098 and the payment of a penalty of $1,077,500. The final judgement also directs Paradise Investment Center LLC to pay, on a joint and several basis with the other defendants, disgorgement of $2,155 million along with prejudgment interest of $119,583 which is deemed satisfied by amounts already collected. See Lit. Rel. No. 24366 (Dec. 6, 2018).

Improper distribution: In the Matter of KCAP Financial, Inc., Adm. Proc. File No. 5-18912 (Dec. 4, 2018) is a proceeding which names as a Respondent the firm which is a closed end investment company that is regulated as a business development firm. As such the firm distributed about 98% of its investment income. Over a four year period, beginning in 2010, the firm distributed about $35.8 million received from its wholly-owned Asset Manager Affiliates. The distribution was inappropriate because it was paid from current or accumulated tax basis earnings and profits. A restatement resulted. During the process the firm concluded its internal controls were not effective. The Order alleges violations of Exchange Act sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) and Investment Company Act section 19(a). To resolve the proceedings Respondent consented to the entry of a cease and desist order based on the sections cited in the Order.

Misallocation: In the Matter of Fifth Street Management, LLC, Adm. Proc. File No. 3-18909 (Dec. 3, 2018) is a proceeding which names as a Respondent the previously a registered investment adviser. In 2013 and 2014 the Order alleges that the adviser improperly allocated rent and overhead expenses to the business development clients as well as certain compensation expenses. The adviser also failed to conduct quarterly valuation models for illiquid assets which ultimately resulted in the overvaluing of two portfolio companies and incorrect financial statements. The adviser did not properly implement written policies and procedures. The Order alleges violations of Securities Act section 17(a)(2) and Exchange Act sections 13(a), 13(b)(2)(A), 13(b)(2)(B) and Advisers Act sections 206(2), 206(4), 207 and 204A. To resolve the proceedings the adviser consented to the entry of a cease and desist order based on the sections cited in the Order and to a censure. The Adviser also agreed to pay disgorgement of $1,999,115.86, prejudgment interest of $334,545.65 and a penalty of $1,650,000.

Offering fraud: SEC v. Suleymanov, Civil Action No. 18-68545 (E.D.N.Y. Filed Dec. 3, 2018). Mark Suleymanov, operating under the business name SpotFN, offered and sold binary options to customers throughout the United States on a series of websites over a period of four years beginning in 2012. The binary options offered by SpotFN were short term contracts tied to the price of stocks and stock indexes or other financial assets. The options offered and sold required an investor to choose if the given stock’s price, for example, would be above or below a specific price at a certain time. If the investor made a correct determination, he or she won a specified amount. If not, the investor received nothing. Mr. Suleymanov represented that the binary options sold were legitimate, using the NASDAQ logo. In fact they were rigged so that investors could almost never win. Not only were the returns not 88% in favor of the investor as claimed, Mr. Suleymanov manipulated the software that ran the options program so that the chance for investors to secure a favorable result were diminished. In addition, while investor funds were supposedly held in segregated accounts, in fact they were not. Rather, investor funds were co-mingled and at times used for the payment of expenses by Defendant. The complaint alleges violations of Securities Act sections 5 and 17(a) and Exchange Act section 10(b). Defendant Suleymanov agreed to the entry of a permanent injunction based on the sections cited in the complaint. Issues regarding disgorgement, prejudgment interest and a civil penalty will be considered by the Court. See Lit. Rel. No. 24364 (Dec. 3, 2018).

Anti-Corruption Cases

U.S. v. Ho, No. 1:17-cr-00779 (S.D.N.Y.) is an action in which defendant Chi Ping Patrick Ho, A/k/a Patrick C.P. Ho, was found guilty by a jury of participating in a multi-year multimillion dollar scheme to bribe top officials of Chand and Uganda to obtain certain business advantages for CEFC China Energy Company Limited. Mr. Ho was found guilty of conspiracy to violate the FCPA, conspiracy to engage in international money laundering, violating the FCPA and engaging in international money laundering. The scheme had two facets designed to aid CEFC China, a Shanghai-based multibillion business conglomerate that operates in oil, gas, and banking. Mr. Ho was at the center of the scheme as the head of a non-governmental based Hong Kong and Arlington, Virginia based China Energy Fund Committee which held “Special Consultative Status” with the U.N. Economic and Social Council. It was funded by China. Under both facets of the scheme Mr. Ho payed bribes to government officials to secure benefits.

U.S. v. Jiminez Aray, No. 9:18-cr-80054 (S.D. Fla. Sentenced Nov. 29, 2018). Gabriel Arturo Jimenez Aray, a Venezuelan business man and the former owner of Banco Peravia, was sentenced following his earlier guilty plea under seal to one count of conspiracy to commit money laundering. Mr. Jamenez admitted as part of the plea to participating in the scheme with Mr. Gorrin and others to acquire Banco Peravia. He then used the bank to launder bribe money. Mr. Jimenez admitted facilitating illegal transactions and bribe payments to foreign officials using bank issued credit cards, cash disbursements, wire transfer and through other transactions, according to his admissions. U.S. v. Jiminez Aray, No. 9:18-cr-80054 (S.D. Fla. Sentenced Nov 29, 2018).

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Lorenzo and Primary Liability: An SEC Win at the High Court?

The Supreme Court heard argument on the question frequently referred to in the circuit and district courts as scheme liability on Monday, December 3, 2018. Lorenzo v. SEC, No. 17-0077. Specifically, the question as framed by Petitioner Francis Lorenzo is “whether the D.C. Circuit erred in concluding a misstatement claim that does not meet the elements set forth in Janus [Janus Capital Group, Inc., v. First Derivative Traders, 564 U.S. 135 (2011)] can be repackaged and pursued as a fraudulent scheme claim under Section 10(b) of the Exchange Act . . . and Section 17(a)(1) of the Securities Act.” The D. C. Circuit and the Securities and Exchange Commission had rejected the contention.

Background

Frank Lorenzo was a director at investment bank Charles Vista, LLC in February 2009. The firm’s largest investment banking client was start-up W2Energy Holdings, Inc. That firm’s business depended largely on the success of certain technology which failed. The firm sought to raise about $15 million through the sale of convertible debentures with the assistance of Charles Vista.

Mr. Lorenzo emailed two potential investors “several key point” about W2E’s pending debenture offering. The emails failed to mention the recent devaluation of the firm’s assets. To the contrary investors were told that there were “3 layers of protection.” One of the messages stated it had been sent at the request of Gregg Lorenzo, the owner of the firm (no relation to Petitioner). Specifically, Mr. Lorenzo, the only witness who testified before the ALJ, stated that he sent emails at the behest of his boss by cutting and pasting – he did not write them.

While the Initial Decision found that that Mr. Lorenzo did not read the text of the emails, that they were sent “without thinking,” the ALJ concluded that Mr. Lorenzo had acted willfully with the intent to deceive, manipulate, or defraud in violation of the statutes. A cease and desist order was entered along with a $15,000 penalty and a life time bar from the securities business. The Commission affirmed as did the D.C. Circuit.

The briefs of the parties centered on the question of primary liability under Janus and whether the SEC could circumvent the dictates of that case by alleging scheme liability in violation of subsections (a) and (c) of Rule 10b (see discussion here).

Petitioner’s argument

Petitioner Lorenzo began the argument by citing to Janus for the proposition that “only the maker of a misstatement can be held liable for that misstatement under Section 10(b) and Rule 10b-5.” While the lower court agreed that is the law under Janus, and that Mr. Lorenzo was not the “maker” of the statements, it found him liable. To reach that conclusion the D.C. Circuit found that Mr. Lorenzo “engaged in a deceptive act, artifice to defraud, or practice, for purposes of liability under Section 10(b) . . .” Permitting liability under this approach would allow “plaintiffs to creatively relabel their inadequate misstatement claims as claims for deceptive devices and acts,” Petitioner claimed.

Justice Sotomayor then asked Petitioner’s counsel about the text of Section 17(a). While Rule 10b-5 uses the phrase “to make” Section 17(a) says something different. The text of that section precludes obtaining “money or property by means of any – of any untrue statement of a material fact.” Since the text of that Section differs from Rule 10b-5 why “should we be treating the two identically” the Justice asked. Petitioner responded that Section 17(a)(2) had not been charged in the case, although he allowed it might have been a better choice for the SEC.

Counsel for Mr. Lorenzo went on to note that typically the courts have differentiate between deceptive conduct and deceptive statements. Since Mr. Lorenzo did not engage in any conduct beyond the misstatements he did not violate the other subsections of Rule 10b he claimed. The Justices did not, however, appear to accept this position. Justice Alito, for example, queried “Well, just take the language of (c). Why doesn’t his conduct all squarely within the language of (c)?” The response was the same from counsel: “because (c) talks about conduct. It’s a type of fraud that’s categorically different than merely misstatements or omissions.” Indeed, if sending an email written by somebody else “constitutes enough of an action to constitute primary liability, it would really leave no room for any sort of aiding and abetting liability.”

Justice Alito was not deterred: “he’s [Lorenzo] a principal under (c) . . . he did the act that is described in (c).” Justice Sotomayor stepped in, pursuing the point by first noting that Mr. Lorenzo conceded he acted with scienter and then stating that “Whether he was a maker or not, he was encouraging the customers to call him directly about buying . . .” the securities offered.

Justice Kagan followed-up, stating that under Central Bank “if your actions fit within the language of the particular provision of the statute that you’re charged on, then you’re a primary violator of that provision. Right?” While Counsel for Petitioner tried to retreat to the argument that the conduct involved here does not fall within the language of the statute, Justice Kagan continued to push the point. Later Justice Breyer essentially affirmed the notion, stating that “And so, fine, then he’s not the maker. But it seems pretty bad. I mean, he’d been working with this company for quite a long time and these investors. And so what is it that makes this aiding and abetting? Maybe he didn’t make the statement, but he was sure a big deal participant.”

Respondent’s argument

Counsel for the Government opened with a focus on the facts: “Petitioner’s decision to send emails that grossly misrepresented the financial prospects of his client and to give illusory promises designed to deceive investors into backing a business that he knew was failing constitute a quintessential securities fraud. His conduct falls within the plain text and the common-sense meaning of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and subsections (a) and (c) of Rule 10b-5.”

Chief Justice Roberts noted that the opening argument offered by Respondent “sounds like the argument your – your client made in Janus that was rejected by this Court.” Counsel immediately noted that 10b-5(b) was the predicate for that case, a subsection not at issue here. Justice Ginsburg picked up the point, asserting that Petitioner’s claim the argument being made “is just an end run around Janus.” The Government rejected this contention, noting first that Janus will continue to have vitality. The critical point, however, is one referenced by Justice Kagan who “said, Central Bank was very clear that the test for primary liability is simply that the defendant has to satisfy all the elements. And – Central Bank says expressly that even if somebody is a secondary actor in some colloquial sense, like a lawyer or an accountant, that person can still be primarily liable under the securities laws if that person satisfies all of the statutory requirements, as Petitioner did here and as I don’t take him to seriously contest.” Justice Gorsuch attempted to interject with a multi-step question that appeared designed to undercut the Government’s position. The point, however, seemed to be lost when other Justices interjected.

The Government shifted the argument back to the conduct noting: “And this email was extraordinarily deceptive, as was commented earlier. There were – there were three gross mischaracterizations of the company under the representation that they would provide different layers of protection.” Returning to Janus Respondent reiterated the established point that the Court there was only concerned with (b) and the meaning of that subsection. This is what Respondent called the “real flaw in Petitioner’s argument, which is, again, that subsection (b) somehow restricts the meaning of (a) and (c) in Rule 10b-5 and also somehow restricts the meaning of subsection (a) of a completely different statute, the Securities Act of 1933.” That is simply incorrect.

Later in the argument Justice Breyer seemed to sum-up stating: “But I just wondered why this isn’t fairly simple, because now that we did in Janus is we took a category of things which we thought the maker had made the false representation, and we thought, no, he wasn’t the maker, but, still, he might be the big boss of a group of people who, in fact, took actions or made statements to cause the false representation to arise in the mind of the listener. I thought perhaps you would agree.” Respondent did agree.

Comment

Lorenzo presents a straight forward issue regarding the language of Section 10(b) and the rule under it and Janus which focused on one word in one subsection of Rule 10b-5(b). The question, often raised by the SEC, was if a case predicated on false statements could escape what appeared to be the Janus trap — that only the maker could be a primary violator. Here since Mr. Lorenzo is not the “maker” under everyone’s reading of the record, there appeared to be clear error.

A critical point threaded through Lorenzo, however, is that he acted with scienter. Precisely how that point became established under the facts as found by the ALJ here is at times difficult to understand. The admission makes Mr. Lorenzo appeared to be intentionally acting to deceive the clients rather than simply bumbling about at the behest of his boss by cutting and pasting emails together as told. Stated differently, Mr. Lorenzo moved from being a secondary actor to a primary one if Janus did not preclude primary liability for those who are not makers.

The Central Bank holding, repeated referenced throughout the arguments, appears to negate the notion that Janus somehow precludes primary liability in this case. To the contrary, as Central Bank directs, if the conduct is prohibited by the text of the statute the actions can only constitute a primary violation. That is the reason Central Bank found that Section 10(b) does not encompass aiding and abetting liability despite decades of prior circuit and district court decisions. Here that same simple notion may well mean that the SEC will prevail in the Supreme Court after a string of difficult losses.

Program: The Fifth Annual Dorsey Federal Enforcement Forum will be held on December 5, 2018. The program, centered on a tech theme and SEC enforcement, includes a keynote address on artificial intelligence and its impact on the legal profession, panels analyzing critical issues facing SEC enforcement, the question of broker protocols, trends in investment adviser inspections, how to conduct an ICO and concludes with an address on cyber-security and internal controls. A holiday gathering follows. The program and registration for it and the party are here.

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