by T. GormanPosted on Posted in SECActions

The distinction between primary and secondary liability has been repeatedly litigated in securities damage cases, and to a lesser extent in SEC enforcement actions, since the Supreme Court handed down its decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). The Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) drew the primary liability line, focusing on who has control regarding the making of a false statement.

Janus many now be creating a new division. Recently, in SEC v. Kelly, Case No. 08 CV 4612 (S.D.N.Y.) the court considered the application of the Janus rule in a false statement case. The action centered on a fraud at AOL from 2000 to 2003 involving round trip transactions between the company and its vendors. AOL is alleged to have structured transactions so that a counterparty purchased advertising. The company then made false statements regarding the transactions to inflate its revenues.

Following the decision in Janus two executives named as defendants in the case requested judgment on the pleadings as to the SEC’s Rule 10b-5 claims. Specifically, the two defendants claimed that they did not “make” the statements in the Janus sense because they did not have control. The SEC conceded the point but argued that Janus is limited to subsection (b) of Rule 10b-5. The Commission sought to hold the defendants liable under subsections (a) and (c) which focus on scheme liability.

The court rejected the SEC’s contention, ruling in favor of the defendants. While the Commission is correct that Janus is based on subsection (b), where the “primary purpose and effect of a purported scheme is to make a public misrepresentation or omission, courts have routinely rejected the SEC’s attempt to bypass the elements necessary to impose ‘misstatement’ liability under subsection (b) by labeling the alleged misconduct a ‘scheme’ rather than a ‘misstatement’” the court held. If scheme liability could be used to evade the requirements of Janus then the distinction between primary and secondary liability would evaporate.

In this case the focus is on false statements. There is nothing inherently deceptive about the underlying transactions. Accordingly, the SEC can not expand primary liability here by invoking scheme liability.

The court also dismissed the SEC’s claims under Securities Act Section 17(a). While Janus did not address the question of liability under this section, since it is “essentially the same” as Section 10(b) and Rule 10b-5, the same test of primary liability crafted in Janus should apply. Accordingly, the court granted the defendants’ motion for judgment on the pleadings.

The court in Hawaii Ironworkers Annuity Trust Fund v. Cole, Case No. 3:10CV371 (N.D.Oh. Decided Sept. 7, 20911)(discussed here) reached the opposite result. There the plaintiffs sought to hold executives who worked in the operating divisions of now bankrupt Dana Corporation primarily liable for false statements about the financial condition of the company. Plaintiffs claimed that a wide spread financial fraud was orchestrated at the company by its former CEO and CFO. Senior officials at the company repeatedly made false statements regarding the financial condition of the company. Executives in the operating divisions, including the defendants, were directed to prepare false financial data for the statements.

Following Janus the court held that the defendants were not primary liable because they did not control the making of the statements. Accordingly, the claims under Rule 10b-5-2 were dismissed. The court went on to hold, however, that those same defendants could be held liable under subsections (a) and (c). Here the defendants engaged in manipulative conduct according to the allegations of the pending complaint. Therefore the claims under subsections (a) and (c) of the rule were not dismissed. See also SEC v. Daifotis, No. 3:11-c-00137 (N.D. CA.)(applying Janus but not considering subsections (a) and (c) as discussed here).

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by T. GormanPosted on Posted in SECActions

The Commission brought another enforcement action arising out of the multi-million loss suffered by five Wisconsin school districts induced to purchase highly leveraged notes tied to the performance of synthetic collateralized debt obligations or CDOs. In the Mater of RBC Capital Markets, LLC, Adm. Proc. File No. 3-14564 (Sept. 27, 2011). The prior action was brought against Stifel, Nicolaus & Co. and a former senior executive of that firm (here). That action is in litigation.

The latest case names as a Respondent RBC Capital Markets Corp, or RBCCM, which has been registered with the SEC as a broker dealer since 1977. During the time period of this action the firm was a wholly owned indirect subsidiary of Royal Bank of Canada, or RBC. That bank was ultimately the counterparty to the transactions with the five school districts as it paid the promised interest on the CDO investments and was the purchaser of default protection on the CDO portfolio.

The transactions focused on investments sold to five school district as a mechanism to fund their employee benefits. Prior to 2005 those benefits were unfunded. The districts paid them as they arose. Stifel created a plan to fund those liabilities. The centerpiece of the program was leveraged investments linked to CDOs. The program called for the school districts to invest largely borrowed funds in notes tied to the performance of synthetic CDOs made up of a portfolio of credit default swaps on corporate bonds. In essence the program called for the school districts to insure the performance of a select group of corporate bonds with public money.

The investments were highly leveraged to increase the potential return. The leverage also magnified the downside risk. The fact that portfolio losses of only 5 to 6% would result in investor losses and there was only a 1% difference between a complete recovery and total failure amplified the risk. If the program was a complete success, it would only cover a small fraction of the unfunded liabilities of the school districts. Failure would result in millions of dollars in losses.

The typical buyers of investments such as those sold to the school districts were hedge funds, pension funds and insurance companies with significant fixed income assets. These entities tended to be highly sophisticated in financial and investment matters and knowledgeable regarding their complexities. In contrast, the school districts had no prior experience investing in CDOs. Previously, the districts invested largely in cash equivalent instruments.

Not only did Respondent fail to properly assess the suitability of the school districts, according to the Order, but it essentially ignored its own misgivings about selling this product to them. Those misgivings included:

· In May 2006 in response to an RFP from Stifel on behalf of the school districts regarding the investments, Respondent noted that “assessing suitability” would be a “critical hurdle” to a transaction and that additional work had to be done to ensure that the districts understood the investments;

· An internal memo noted that the investments were only suitable for the most sophisticated government entities;

· After reviewing Stifel’s presentation materials, RBCCM concluded that they did not provide a full explanation while observing that the investment program did not appear to provide significant benefits;

· The firm’s Municipal Finance group declined an opportunity to work with Stifel on the marketing;

· During a series of discussions, executives had a range of opinions as to whether the investments had been properly explained, if the firm should meet with representatives of the districts or whether RBCCM should avoid taking additional steps to know the clients so it could be in a situation to avoid responsibility for any suitability determination.

· The focus of the internal discussion at RBCCM concerned insulating the firm from liability.

Eventually the firm decided to rely on Stifel and not meet with representatives of the school districts. At the time of the first sale to a school district in June 2006 the firm attempted to make Stifel solely responsible for suitability. Stifel did not want the responsibility. Ultimately however Stifel agreed to permit the investments to “pass through” the firm to the district.

Nevertheless, the next month RBCCM pitched its CDO products to the school districts, discussing their merits and providing a historical analysis. The presentation helped convince the school districts to invest in the CDOs.

In September, and later in December 2006, RBCCM agreed to sell the CDOs directly to the school districts as long as Stifel provide a side letter addressing suitability. While the letter made it clear that Stifel thought the investments were suitable, it went on to provide that the firm had not done any independent analysis of them. In essence, Stifel stated that it was relying on the school districts to determine the suitability of the investments.

In fact the investments were not suitable, according to the Order. The investments were not compatible with the goals of the school districts, their lack of sophistication and their sensitivity to losing their investment. The proposed investments were also far riskier than those undertaken by the school districts. RBCCM also knew that the districts were risking their entire pension benefits investment portfolio without any diversification. In addition, the firm knew that the investments were highly leveraged with $197.7 million of the $200 million investment coming from borrowed funds.

The presentations made by RBCCM to the school districts were also inadequate. Specifically, they understated the risks, misstated the selection criteria and failed to adequately explain the method for evaluating the risks.

The initial investments by the school districts immediately suffered difficulties. Ultimately the program collapsed. The lending bank took all of the investments. The five school districts lost all of their investments. There were millions of dollars in losses.

The Order alleges violations of Securities Act Sections 17A)(2) and (3).

RBCCM resolved the matter by consenting to the entry of a censure and a cease and desist order based on the sections cited in the Order. Respondent also agreed to pay disgorgement of $ 6 million along with prejudgment interest and a $22 million civil penalty. The funds are to be paid directly to the school districts. The Order specifies that in any related civil action RBCCM cannot claim the amounts paid in this proceeding as an off-set and, if they do, that an equal amount must be paid to the school districts. A fair fund was established.

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