A STREAM OF INVESTMENT SCHEME FRAUD CASES

Once, it was thought that various kinds of investment frauds and Ponzi schemes were difficult to detect. Market regulators such as the SEC were hard pressed to find them. The market crisis, Madoff and now Stanford seem to have changed all that. Now, these schemes seem to be a staple of SEC enforcement.

Two more of these cases were brought on Monday by the SEC. SEC v. Bluestein, Case No. 2:09-CV-13809 (E.D. Mich. Filed Sept. 28, 2009); and SEC v. K&L International Enterprises, Inc., Case No. 6:09-CV-1638 (M.D. Fla. Filed Sept. 28, 2009).

Bluestein is an action against Detroit area stock broker Frank Bluestein. Mr. Bluestein, according to the complaint, served as a feeder for Edward May and his Ponzi scheme E-M Management LLC. Mr. Bluestein targeted elderly investors, sometimes inducing them to refinance their homes to secure funds for the scheme. To lure the investors, Mr. Bluestein conducted investment seminars where he discussed various investment topics. After winning their confidence, Mr. Bluestein used a variety of misrepresentations to obtain their investment. Typically, he assured potential investors that the fund was low risk and that he had carefully investigated its operations without telling them about his large fees. In fact, Mr. Bluestein had done little to investigate the fund which was actually a Ponzi scheme. Using this approach Mr. Bluestein raised about $74 million from more than 800 investors over a five-year period.

The Commission’s complaint alleges violation of the antifraud and registration provisions of the securities laws. The case is in litigation.

In K&L International, the SEC obtained emergency relief against defendants Stephen Carnes, Lawrence Powalisz and their related companies. This scheme focuses on dumping unregistered shares on the market. It involves two groups of companies, the “Stock Distributor Defendants” and the “Issuer Companies.” According to the complaint, the defendants used these companies to dump billions of shares of microcap company shares onto the market. The shares were quoted in the Pink Sheets or the Over-the-Counter Bulletin Board.

The scheme to distribute the shares contained four key steps: 1) the Stock Distributor Defendant either claimed to lend money to an Issuer Company or the Issuer Company identified a debt to its officer that it assigned to the Stock Distributor Defendant; 2) the Stock Distributor Defendant paid the Issuer Company or an affiliate; 3) the loan or assigned debt was reduced or eliminated by the Issuer Company issuing shares of its stock to the Stock Distributor defendant; and 4) the Stock Distributor Defendant dumped the shares onto the public market.

Over a two year period the defendants raised about $7 million through this scheme. The complaint alleges violations of Section 5 of the Securities Act. The case is in litigation.

ARE CORPORTE EXECUTIVES PLAYING RUSSIAN ROUELETTE?

With the passage of the Sarbanes Oxley Act, Congress imposed an array of duties on corporate executives. Section 302 for example requires the CEO and CFO to file certifications regarding the financial information of the company. Section 304(a) requires those same individuals to repay certain incentive-based compensation and stock trading profits if the company has to restate its financial statements as a result of misconduct and for failing to comply with financial reporting requirements. A key point of SOX is to encourage corporate executives to enhance monitoring to protect shareholder investments.

SEC v. Jenkins, Case No. CV-09-01510 (D. Ariz. Filed July 22, 2009), discussed here, alleges a violation of Section 304(a) by the defendant CEO. The case raises fundamental questions about the purpose of SOX and the vision of SEC enforcement in its application of the Act.

Until Jenkins, the SEC had invoked Section 304 in enforcement actions to obtain disgorgement where the CEO or CFO engaged in misconduct. Jenkins is different. There, the SEC filed an action claiming that Maynard Jenkins, who was the CEO of CSK Auto Corporation, failed to repay his incentive compensation and stock trading profits. Mr. Jenkins was in fact the CEO of the company during a period when there was a massive accounting fraud resulted in a restatement as discussed here.

What makes Jenkins different? The SEC acknowledges that Mr. Jenkins did nothing wrong. None of the enforcement actions brought by the SEC and DOJ even suggest that Mr. Jenkins was involved in or responsible for wrong doing. The complaint is simple strict liability: if it happened on the watch of CEO Jenkins, so he must pay.

Mr. Jenkins has filed a motion to dismiss challenging the SEC’s contention that Section 304 creates a strict liability cause of action. Essentially, the brief argues that Section 304 should be viewed as a remedy, applied in conjunction with other sections where there is wrongdoing as has been done in earlier SEC cases. The motion makes three key points. First, the SEC’s interpretation of the Section would impose punishment on those who are innocent. This position would violate both the constitutional guarantee of due process and its prohibition against excessive punishment. Since statutes should be construed if possible to avoid a constitutional infirmity, the Commission’s interpretation should be rejected. Rather, Section 304 should be read as requiring wrongdoing by the defendant, a reading, which avoids the constitutional difficulties.

Second, the case law and the legislative history support a reading of the Section which would require wrong doing. Both the Ninth Circuit in In re Digimarc Corp., Derivative Litigation, 549 F.3d 1223 (9th Cir. 2008) and the legislative reports refer to the Section as requiring “disgorgement” which is a remedy utilized against persons with ill-gotten gains from wrongful conduct.

Finally, the Section was not intended to be a new cause of action. Congress is generally presumed to legislate against a background of common law principles unless there is evidence to the contrary. Under basic common law agency principles, an officer of a corporation is not vicariously liable for the actions of the employee, the brief argues. The SEC however, reads the Section as disregarding this principle. This radical departure from basic agency principles should be rejected.

Regardless of the outcome here, Jenkins raises fundamental questions about SEC enforcement. No doubt executive compensation is a hot topic these days, particularly where, as here, the CEO is handsomely rewarded as a huge accounting fraud moves forward. At the same time however, applying Section 304 as a strict liability cause of action rather than as a remedy would undercut the purpose of SOX. The point of having CEO and CFO certifications as well as the other obligations imposed on corporate officials by SOX is to require those at the top to closely monitor key matters at the company. These intensified obligations are consistent with the traditional obligations of senior corporate officials and the notion that they are the stewards of other people’s money, that of the shareholders.

Section 304, as part of SOX, should be read in conjunction with the other provisions of the Act. Read in that context, it is the back side of the intensified monitoring obligations imposed by the Act – when monitoring fails, the executives will pay. When applied in this manner, the Section should serve its intended purpose which is to spur executives to be more vigilant for shareholders. In contrast, read the way the SEC is interpreting the Section in Jenkins, it becomes Joseph Heller’s classic novel “Catch 22” – no matter how good of a job the CEO and CFO do, they may punish them. This approach does not encourage the kind of conduct Congress sought with SOX, it undercuts it.

Finally, the SEC’s interpretation also calls into question its vision of enforcement. While it clearly is “tough,” undercutting the congressional purpose of the statutes is clearly not good enforcement. If the SEC wants to take a strong position on the application of Section 302, it should consider issuing a Section 21(a) report interpreting the Section in a manner which encourages corporate executives to enhance their monitoring duties consistent with the Act. Otherwise corporate executives will be left in a standardless void where no matter how hard they work and how good of a job they do they might be penalized. In that case being a CEO or CFO might start to feel like playing Russian roulette.