This Week In Securities Litigation (Week starting July 22, 2019)

The passing of retired Supreme Court Justice John Paul Stevens is a huge loss not just for the legal profession but for all. The courtesy, civility and thoughtfulness he represented will be sorely missed, particularly today when incivility tending toward the uncouth seems to be not just an emerging trend but a coveted character trait.

One of the most significant opinions authored by Justice Stevens is, of course, a landmark in administrative law – Chevron U.S. Inc. v Natural Resources Defense Counsel, Inc., 497 U.S. 337 (1984). From the case holding that an administrative agency is entitled to deference when interpreting an ambiguous statutory scheme Congress directed it to administer, the decision has grown to stand for administrative deference virtually always. Indeed, the Second Circuit has given Chevron deference to a settled SEC administrative proceeding. VanCook v. SEC, 653 F. 3d 130, 140 n. 8 (2nd Cir. 2011)(concluding that an SEC position in a settled administrative proceeding on market timing “trumped” a prior decision of the Court based on Chevron).

The future of deference may be pocked with difficulty, however. On the last day of the Term the Supreme Court handed down Kisor v. Wilkie, No. 18-15 (June 30, 2019), delimiting the reach of what is called Auer deference but refusing to overturn it. See also Auer v. Robbins, 519 U.S. 452 (1997). Perhaps the most interesting feature of the decision is the opinion written by Chief Justice Roberts stating that “the distance between the Majority and Justice Gorsuch is not as great as it may initially appear.” Roberts, C.J. (concurring in part) at 1. Justice Gorsuch dissented. It is perhaps ironic that the defendant in Chevron was the then EPA Administrator Anne M. Gorsuch, the Justice’s mother. While Kisor rejected an invitation to overturn Auer, the question of deference is far from settled.

SEC

Release: The Commission and NASAA issued a summary that explains the application of the federal and state securities laws to opportunity zone investments (July 15, 2019)(here).

SEC Enforcement – Filed and Settled Actions

The Commission filed 9 civil injunctive action and 3 administrative proceedings this week, exclusive of 12j and tag-along actions.

Financial fraud: SEC v. Winemaster, Civil Action No. 24544 (N.D. Ill. Filed July 19, 2019) is an action which names as defendants executives of Power Solutions International, Inc: CEO Gary Winemaster, V.P. of Sales Craig Davis, and General Manager of Industries James Needham. Over a one year, period beginning in the fourth quarter of 2014, Defendants caused the firm to falsify its revenues in an effort to meet certain targets. Specifically, in each quarter during the period defendants falsified the revenues using devices which included: Recognizing revenue for sales were the customer had not agreed to accept the product, were the sale had not been completed to customer specifications, where there were side agreements with rights of return and where the amount recorded exceeded the actual sales price. Revenue was falsely inflated by over $24 million. During the course of the fraud Defendants also deceived members of the accounting department. Beginning in 2016 information regarding the fraud was included in various Form 8-K filings. Restated financial statements were filed in 2017. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B), 13(b)(5), and 20(A) and SOX Section 304. The case is pending. See Lit. Rel. No. 24544 (July 19, 2019). The U.S. Attorney’s Office for the Northern District of Illinois filed a parallel criminal action.

Overcharging: SEC v. Alar, (N.D. Ga. Filed July 18, 2019). Defendant Paul Alar is the owner and operator of West Mountain, LLC, also a defendant, which has acted as an investment adviser for years. West Mountain advises two pooled investment vehicles which each paid a management fee and a second fee based on the value of the assets. Each acted as a fund of funds until 2016. After that year the investments of the two funds were shifted by Mr. Alar. Each fund was instructed to make direct investments in the subsidiaries of two privately held companies, a Petroleum Company and an Aircraft Company. Mr. Alar and the advisor then directed each fund to record its investment as an unrealized gain. That resulted in 44% of one fund’s assets and 22% of the other fund’s assets being invested in either the Aircraft or Petroleum Company. Together the transactions represented $18.6 million in unrealized revenue. The valuations were based on two previously prepared valuation reports each of which stated that it was not an “independent valuation” and did not constitute a “formal opinion of value.” Requests by the investors for a copy of the reports were denied. The increased valuations permitted Defendants to collect an additional $900,000 in advisory and performance fees. In June and July 2017, West Mountain’s independent audit firm “disclaimed opinions” to the funds because of the valuations regarding the Aircraft Company and Petroleum Company. Nevertheless, Defendants continued to rely on the valuations to collect fees. The amount of excess fees collected by relying on the two opinions approximated the sum owed by Mr. Alar under an adverse divorce decree entered during this period. The complaint alleges violations of Advisers Act Sections 206(1), 206(2) and 206(4). The case is pending.

Fraudulent valuations: In the Matter of Swapnil Rege, Adm. Proc. File No. 3-19257 (July 18, 2019) names Mr. Rege as a Respondent. He was employed as a portfolio manger with Fund Adviser for about two years beginning in March 2015. Mr. Rege used inconsistent valuation methods from June 2016 through April 2017 to value similar assets. Specifically, he used different discount curves to arrive at the net present value of long and short positions in certain swaps and options on interest rate swaps that had similar characteristics. If the instruments were valued by the same method the positions should have had essentially offsetting values. Instead profits were record which resulted in excessive fees. The Order alleges violations of Advisers Act Sections 206(1), 206(2) and 206(4). To resolve the proceedings Respondent consented to the entry of a cease and desist order based on the sections cited in the Order. In addition, Respondent was barred from the securities business with the right to apply for reentry after three years. Respondent was also directed to pay disgorgement of $600,000, prejudgment interest of $49,170.44 and a civil penalty of $100,000.

Manipulation: SEC v. O’Rourke, Civil Action No. CV19 4137 (E.D. N.Y. Filed July 17, 2019) is an action which names as defendants Garrett M. O’Rourke and Michael J. Black, each of whom owns various microcap companies. Over a three year period, beginning in May 2016, Defendants schemed to fraudulently sell shares in three microcap issuers they controlled. During the period Defendants, who controlled the firms, targeted elderly investors and others to sell the stock. Typically, potential investors were furnished with false statements regarding the firm. The sales pitch regarding the shares was coordinated with selling the Defendants’ shares into the market at inflated prices. Defendants also concealed the fact that they owned controlling interests in the shares of the firms whose stock was being sold. During the sale of the shares for one of the firms, a person was recruited that was believed to be a broker. In fact, the person was an undercover FBI agent. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). The Commission secured a freeze order. See Lit. Rel. No. 24543 (July 19, 2019). The U.S. Attorney’s Office for the Eastern District of New York filed a parallel criminal action.

Offering fraud: SEC v. Skelley, Civil Action No. 18-cv-8803 (S.D.N.Y.) is a previously filed action which names as defendants the co-founders and executives of crowd funding company, Funding LLC, Willliam Skelley and Sohin Shah. The complaint alleged that defendants misappropriated over $1 million of investor funds after deceiving them with misrepresentations regarding the amount of investor funds and their use. Defendants resolved the matter consenting to the entry of permanent injunctions based on Securities Act Section 17(a) and Exchange Act Section 10(b). The order as to Mr. Skelley, entered by default, provides for consideration of monetary remedies in the future. As to Mr. Shah the judgment directs the payment of disgorgement and prejudgment interest of $73,794 and a penalty of $75,000. See Lit. Rel. No. 24536 (July 17, 2019).

Unregistered broker: SEC v. Kouyoumdjian, Civil Action No. 19-cv-61773 (S.D.N.Y. Filed July 16, 2019) is an action against Emmanuel Koyyoumdjian, a disbarred stockbroker. The complaint alleges that he acted as an unregistered broker in selling the securities of ForceField Energy, Inc. Previously, an action was brought against the firm and others for the sale of unregistered securities by unregistered brokers. Defendant here participated in those efforts. The complaint alleges violations of Securities Act Sections 5(a) and 5(c) and Exchange Act Section 15(a)(1). The case is pending. See Lit. Rel. No. 24535 (July 17, 2019).

Fraudulent purchases: SEC v. Saltsman, Civil Action No. 07-cv-4370 (E.D.N.Y.) is a previously filed action which named Zev Saltsman and Ethan Saltsman. the representatives of an Israeli investor group, as defendants. Defendants represented the group with respect to purchasing controlling blocks of stock in two publicly traded companies while misleading the public about the group. Kickbacks were paid in connection with the transaction. Each defendant resolved the action, consenting to the entry of a permanent injunction based on Securities Act Sections 5(a), 5(b)(2) and 5(c) and 17(a) and Exchange Act Sections 13(d) and 16(a). Ethan will pay disgorgement of $500,000 while Zev will pay $5 million which is deemed satisfied by the payment of restitution in the parallel criminal case. See Lit. Rel. No. 24534 (July 17, 2019).

Fraudulent merger charges: SEC v. AR Capital, LLC, Civil Action No. 1:19-cv-06603 (S.D.N.Y. Filed July 16, 2019) is an action which names as defendants: The firm, a manager of American Realty Capital Properties, Inc. and the sponsor of two publicly held, non-traded REITs (American Realty Capital Trust III or T3 and American Realty Capital Trust IV or T4); Nicholas Schorsch, who controls AR Capital and is the CEO of T3 and T4; and Brian Block, the CFO of T3 and T4. Through two separate mergers involving ARCP and T3 and ARCP and T4, and without the consent of the board, the individual defendants obtained 2.9 million operating partnership units to which they were not entitled. The individual defendants also directed and approved misleading asset purchase and sale agreements through which AR Capital obtained $5.8 million from ARCP in connection with each merger. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 13(b)(5). Defendants resolved the claims, each consenting to the entry of a permanent injunction based on the sections cited in the complaint as to Mr. Block and AR Capital [except Section 17(a)(2) and (3)]and only based on Section 17(a)(2) and (3) as to Mr. Schorsch. In addition, Defendants will pay, on a joint and several basis, disgorgement of over $39 million which includes the wrongfully obtained capital and a penalty of $14 million against AR Capital, $7 million against Mr. Schorsch and $750,000 as to Mr. Block. See Lit. Rel. No. 24537 (July 17, 2019).

Failure to supervise: In the Matter of Nomura Securities International, Inc., Adm. Proc. File No. 3-19248 (July 15, 2019); In the Matter of Nomura Securities International, Inc., Adm. Proc. File No. 3-19249 (July 15, 2019). The cases are substantially similar. Each is based on the trading tactics used by the firm’s traders in what are essentially opaque markets. The first centered on trading residential mortgage backed securities or RMBS during the period January 2010 to November 2013. The traders were Ross Shapiro, Michael Gramins and Tyler Peters. The Order alleges that the “three Nomura RMBS traders misled or lied to investment advisers and other fund managers that were trading RMBS . . .” about the prices and compensation involved in the transactions. The second alleges that traders James Im and Kee Chan “misled or lied to investment advisers and other fund managers that were trading CMBS [commercial mortgage backed securities] . . .” about the prices and other matters. Each Order alleges that the firm failed to reasonably supervise the traders. Each proceeding was settled with a series of undertakings and the entry of an order censuring the firm for failing reasonably to supervise within the meaning of Exchange Act Section 15(b)(4)(E). In the first, Nomura will pay customers $20,704,337. In addition, the firm will pay disgorgement of $16,329,650 and prejudgment interest of $3,792,300. The firm will also pay a penalty of $1 million. Those amounts are satisfied by paying the customers. In the second the firm will pay customers $4,275,035. In addition, the broker will pay disgorgement of $1,133,5000, prejudgment interest of $242,609.67 and a penalty of $500,000. Again, those amounts will be satisfied by paying the customers. These cases are the end of a series of actions brought by the U.S. Attorney and the Commission that are discussed in detail here.

Financial fraud: SEC v. Conn’s Inc., Civil Action No. 4:19-cv-2534 (S.D. Tex. Filed July 15, 2019). Conn’s Inc. is a specialty retailer of consumer goods and credit financing, focused on “credit-constrained consumers .. .” Michael Pope, also a defendant, has held a series of positions in the finance area of the firm including most recently, CFO. He is a CPA. The company has two reportable operating segments, retail and credit. The consumer credit programs are key to the retail segment since the firm focuses on those who lack the cash to make a purchase. Indeed, about 80% of its retail sales are financed through a firm credit program. In view of its business model, it was critically important that the firm properly identify impaired receivables and measure the amount as required by GAAP. Conn’s complied with the loss contingency requirement by accruing an allowance for doubtful accounts that had two key components: 1) Troubled debt restructuring – all accounts for which payment terms have been extended over 90 days or refinanced in bankruptcy; and 2) non- troubled debt restructuring or TDR which was calculated using a complex roll rate. Company policy required that the rate be based on historical trends. Over a two-year period, beginning in 2013, the firm failed to comply with its policy in creating the roll rate. Rather, a “plug” was used which materially overstated revenue. In using the plug the company ignored its actual and projected charge-offs and the variance, increases in the percentage of accounts that were over 60 days past due and the dramatic increase in new customers that resulted as credit standards eased. In the second quarter of fiscal 2015 the firm began to build its allowance for doubtful accounts properly. The role rate was retooled. By December 2014 Conn’s issued a press release admitting that its prior “credit operations forecasting had not been acceptably accurate . . .” A Credit Risk Compliance Committee of the Board of Directors was created. The stock price dropped 41%. During the period the company did not have internal controls adequate to address this issue. The complaint alleges violations of Securities Act Section 17(a)(3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). Defendants resolved the action. Conn’s consented to the entry of a permanent injunction based on the sections cited in the complaint. The firm also agreed to pay a penalty of $1.1 million. Mr. Poppe consented to the entry of a permanent injunction based on the Securities Act Section cited in the complaint. He agreed to pay a penalty of $50,000. See Lit. Rel. No. 24532 (July 15, 2019).

Offering fraud/unregistered brokers: SEC v. Wieniewitz, Civil Action No. 0:19-cv-61738 (S.D. Fla. Filed July 15, 2019) is an action which names as defendants Henry Wieniewitz and his firm Wieniewitz Financial, LLC. Over a two year period, beginning in February 2016, Defendants acted as unregistered brokers for the Woodbridge Group of Companies, LLC, its affiliates and 1 Global Capital, LLC. They raised about $64.4 million from over 630 retail investors, earning about $3.5 million. The investors were not aware that Woodbridge was a massive Ponzi scheme and that 1 Global was being looted by its chairman and CEO. The complaint alleges violations of Securities Act Sections 5(a) and 5(c) and Exchange Act Section 15(a)(1). Defendants resolved the claims with each consenting to the entry of a permanent injunction. Financial remedies will be considered in the future. See Lit. Rel. No. 24531 (July 15, 2019).

Manipulation: SEC v. Lawler, Civil Action No. 1:19-cv-04025 (E.D.N.Y. filed July 12 2019) is an action which names as defendants attorney Lawler and Natalie Bannister. The complaint centers on schemes to transfer control of Broke Out, Inc. and Immage Biotherapeutics Corp. to Client A of Mr. Lawer. First, over a period of several months, beginning in August 2015, the two Defendants orchestrated the transfer of control of Broke Out, a shell company to Client A, using false attorney letters. Second, a similar scheme was executed as to Immage over a two year period, beginning in February 2015. While the shares of the firms were deposited in brokerage accounts and represented to be free trading, in fact they were not. Mr. Lawler also manipulated the shares of Mani Corp from December 2016 through 2018. Each defendant was paid for their services. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 9(a)(1) and (2) and 10(b). The case is pending. The Commission also entered an order as to each entity suspending trading.

Manipulation: SEC v. Honig, Civil Action No. 24529 (S.D.N.Y. Filed Sept. 7, 2019) is a previously filed action based on the manipulation of a microcap stock. Mr. Honig, and his firm, GRQ Consultants, Inc., along with Elliot Maza and Brian Keller, were alleged to have participated in the manipulation. Each consented to the entry of a permanent injunction based on Securities Act Section 17(a) and Exchange Act Section 10(b). The injunction as to Mr. Honig is also based on Exchange Act Sections 9(a)(1) and (2) while the one as to GRQ includes Exchange Act 13(d). The injunctions as to Messrs. Maza and Keller also precludes aiding and abetting of the reporting provisions of Exchange Act Section 15(d). Mr. Honig and his firm are precluded from participating in any penny stock offering and agreed to the entry of conduct based injunctions. Financial remedies will be considered on motion of the SEC. See Lit. Rel. No. 24529 (July 12, 2019).

Criminal Cases

Manipulation: U.S. v. O’Rourke, No. 19-mj-644 (E.D.N.Y. Filed July 18, 2019). Over a one year, period beginning in April 2016, Defendant Garrett O’Rourke induced investors to purchase shares of a firm whose ticker symbol was AVOP by claiming he worked for Marketwise Report, an investment advisory firm in Florida. In fact, he and his co-conspirators were operating a boiler room. By persuading investors to purchase shares with false statements Defendants “pumped” up the share price and then dumped over $2 million in shares at inflated prices, securing a profit. Mr. O’Rourke was arrested at the airport and made his first court appearance on July 18, 2019. The case is pending.

Crypto assets: U.S. v. Montroll, No. 1:18-cr-00520 (S.D.N.Y.). Jon Montroll was the operator of WeExchange Australia, Pty, Ltd. and BitFunder.com The former was a bitcoin depository and currency exchange service. The latter facilitated transactions in virtual shares of entities that listed on BitFunder. Over about seven months, beginning in December 2012, Mr. Montroll misappropriated a portion of investor bitcoins on WeExchange. Several months later he began promoting Likyo.Loan, a security that Mr. Montroll urged investors to view as “a sort of round-about investment” in BitFunder and WeExchange, as well as a loan. The interests could also be redeemed at face value. Hackers penetrated BitFunder’s programing code during the summer of 2013, crediting their accounts. Following the hack Mr. Montroll did not have the bitcoins necessary to cover obligations to users. Mr. Montroll chose not to disclose the hack to investors. Rather, he continued to promote Likyo.Loan, telling at least one investor that it was a commercial success – an incorrect statement. Subsequently, the SEC opened an investigation. During testimony Mr. Montroll displayed a screen shot that supposedly documented the total number of bitcoins available to BitFunder users in the WeExchange Wallet as of October 13, 2013. The representations in the screen shot were false. During the testimony that followed Mr. Montroll falsified the details of the hack. The result: Mr. Montroll pleaded guilty to one count of securities fraud and one count of obstruction of justice. Last week he was sentenced to serve 14 months in prison followed by three years of supervised release. He was also ordered to pay forfeitures in the amount of $167,480. The SEC filed a parallel enforcement action which is pending. SEC v. Montroll, Civil Action No. 1:18-cv-01582 (S.D.N.Y. Filed Feb. 21, 2018).

U.K.

Bribery: Michael Sorby Adrian Leek and David Justice were acquitted of conspiracy to corrupt and conspiracy to bribe in connection with 27 overseas contracts for their firm, Sarclad Ltd. The company previously entered into a deferred prosecution agreement under which it agreed to pay approximately $8.1 million in disgorgement and penalties that were paid by the U.S. parent. The agreement also require the firm to cooperate with the Serious Fraud Office. The company identified the agreements involved based on a report prepared by counsel.

BaFin

Report: The regulator’s 2018 Report is now available here.

Singapore

Agreement: The Monetary Authority of Singapore, or MAS, and the Central Bank of Kenya entered into a FinTech Cooperation Agreement to support digital infrastructure development in Kenya (July 17, 2019). The two banks will collaborate to develop basic digital infrastructure for Kenya (here).

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SEC Charges Advisor With Fraudulently Overcharging Clients

Traditionally the Enforcement Division’s case load centered on corporate and disclosure cases along with a mix of others. In recent years that mix has included a number of offering fraud actions whose victims are often small retail investors. More recently that mix seems to be more heavily weighted with cases involving investment advisers. Many of those cases focus on the failure of the advisory to follow disclosed procedures, although a number are simple fraud actions. The Commission’s most recent case in this area falls into the latter group. SEC v. Alar, (N.D. Ga. Filed July 18, 2019).

Defendant Paul Alar is the owner and operator of West Mountain, LLC, also a defendant, which has acted as an investment adviser for years. West Mountain advises two pooled investment vehicles which each paid a management fee and a second fee based on the value of the assets. Each essentially acted as a fund of funds until 2016.

In 2016 the investments of the two funds were shifted by Mr. Alar. The funds were directed to make direct investments into subsidiaries of two privately held companies. One, a Petroleum Company, was attempting to develop petroleum emulsification products. A second, an Aircraft Company, was trying to manufacture aircraft.

The next year Mr. Alar was appointed to the board of each fund. Subsequently, Mr. Alar and the advisor directed each fund to recorded its investment in either the Aircraft or Petroleum Company as an unrealized gain. As a result, 44% of one fund’s assets and 22% of the other fund’s assets were invested in either the Aircraft or Petroleum Company.

Defendants relied on two previously prepared valuation reports in directing the funds to record the unrealized gains. Those reports were based on cash flow projected provided by each firm. Each was based on untested assumptions which lacked support. Each report also stated that it was not an “independent valuation” and did not constitute a “formal opinion of value.”

Requests by the investors for a copy of the reports were denied. Yet the financial records of the funds collectively reported an unrealized gain of $18.6 million. This permitted Defendants to collect about $900,000 in advisory and performance fees.

In June and July 2017, West Mountain’s independent audit firm “disclaimed opinions” to the funds because of the valuations regarding the Aircraft Company and Petroleum Company. The auditors “indicated that it had evaluated the procedures established by West Mountain to estimate the fair values of the direct investments and believed they were unreasonable.” A follow-up letter to Defendants stated that the valuation procedures were not appropriate and were “inconsistent” with GAAP.

Nevertheless, during 2016 and 2017 Defendants continued to rely on the valuations to collect fees. During the period they also continued to tout the two investments with baseless claims of about to be realized profits by the Petroleum Company and the Airplane Company. The amount of excess fees collected approximated the amounts owed by Mr. Alar under an adverse divorce decree entered during this period. The complaint alleges violations of Advisers Act Sections 206(1), 206(2) and 206(4). The case is pending.

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