by T. GormanPosted on Posted in SECActions

While the partial government shutdown continued the courts were able to remain open, although their websites were not updated. Agencies such as the SEC reduced their staff to a comparative handful. Nevertheless, during the period the Commission was able to prevail in part on a partial motion for summary judgment against a securities law recidivist. Specifically, the Commission secured summary judgement on claims that a hedge fund owner and his fund violated the antifraud provisions of the securities laws by failing to disclose his prior violation of those stattes and permitting selective redemptions. Defendants’ cross-motion for summary judgment was denied as to all counts. SEC v. Conrad, Civil Action No. 1:16-cv-02572 (N.D. Ga. Order entered Jan. 19, 2019).

The complaint

Thomas Conrad and his son Stuart were named as defendants along with Financial Management Corporation and Financial Management Corporation, S.R.L. Thomas had been barred from association with any broker or dealer and the registration of his then broker-dealer firm revoked in a 1971 administrative proceeding which concluded that he was unfit for “engaging in the securities business in any capacity.”

Subsequently, Financial Management Corporation acted as the general partner and unregistered investment adviser for the hedge funds operated by Mr. Conrad under the World Opportunity Fund name, including its successor, World Fund II. A master-feeder arrangement was used. Financial Management Corp. assumed the role of general partner and adviser to the World Opportunity feeder funds. Mr. Conrad appointed himself a sub-adviser to the master. Neither his fees nor his prior violation of the law was disclosed.

In November 2008 Mr. Conrad notified investors that FMC was temporarily suspending all withdrawals, redemptions and terminations of capital accounts in view of the market crisis. Requests to redeem all or part of their investments by 29 investors in 2012 were denied. Nevertheless, Mr. Conrad redeemed about $2 million in one transaction and received other payments. Son Stuart received payments in a number of transactions and redeemed $25,000 from an account. The complaint alleged violations of Securities Act Section 17(a), Exchange Act Section (b) and Advisers Act Sections 206(1), 206(2) and 206(4).

The opinion

The Court granted the Commission’s request for summary judgment on the counts regarding Mr. Conrad’s prior violations of the law and selective redemptions. Defendants admitted the disciplinary history and that it had not been disclosed. They claimed it was not material because it was followed by a number of other positive accomplishments.

To resolve a question of materiality posited by Defendants — typically a mixed question of fact and law — as a matter of law on summary judgment the court “must find the established omissions . . . so obviously important to an investor, that reasonable minds cannot differ on the question of materiality.” Indeed, mixed questions of law and fact are peculiarly within the province of the trier of fact.

In this case, despite Defendants’ claims regarding Mr. Conrad’s background, the “undisputed facts remain that the SEC prohibited Defendant Conrad from ever again associating with a registered broker-dealer and revoked the registration of Conrad & Company, a registered broker-dealer Defendant Conrad controlled.” Also undisputed is the basis for those conclusions: Mr. Conrad willfully aided and abetted violations of the Securities Exchange Act. Those findings cast “aspersions” on Mr. Conrad’s character.

While Mr. Conrad presented evidence of other more recent matters with which he has been involved, the Commission introduced “depositions and affidavit evidence from investors in the funds who stated they would not have invested in the funds had the disciplinary action been disclosed . . .” Stated differently, the undisclosed regulatory history was material and should have been disclosed as a matter of law.

Equally clear is the fact that Defendants preferential redemptions are tied directly to the misrepresentations. Defendants claim that Mr. Conrad had broad discretion to limit redemptions is correct. Their claim that this fact was disclosed to investors is also correct. Neither point changes the fact that Mr. Conrad represented to investors that redemptions were not being permitted and then authorized selective redemptions by others. The undisputed evidence in this case has “established as a matter of law that, over the course of many years, Defendants repeatedly made material misrepresentations regarding the redemption practices of the funds to actual and potential investors in email communications, investor fact sheets, and other offering memoranda. That conduct is prohibited” by Securities Act section 17(a), Exchange Act section 10(b) and Advisers Act section 206(4). Accordingly, summary judgment was granted in favor of the Commission on Counts I, II and IV. See Lit. Rel. No. 24390 (Feb. 4, 2019).

Program: Save the Date of March 19, 2019 for: “Women in Compliance” held at Dorsey & Whitney LLP, 51 West 52nd St. New York, New York, 10019-6119. The program begins at 6:00 p.m. and is followed by cocktails. The announcement is here.

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by T. GormanPosted on Posted in SECActions

Questions regarding the extraterritorial reach of Exchange Act section 10(b) have traditionally presented the courts with difficult factual and legal issues. The Supreme Court’s seminal decision in Morrison v. Nat’l Australia Bank Ltd., 561 U.S. 247 (2010) on the extraterritorial reach of that section added to the complexities. There the Court held that the federal courts have the power, the jurisdiction, to hear cases involving international matters under the Exchange Act. Nevertheless, the Court concluded that section 10(b) did not reach fraudulent conduct unless the securities transaction took place either on a U.S. exchange or within the country. That conclusion was based on the presumption that statutes do not have extraterritorial reach absent an indication in the statutory text that Congress intended to confer that authority. That intent is not evident from the text of section 10(b).

Shortly after the High Court handed down Morrison, Dodd-Frank was signed into law. Section 929(p) of that Act amended the jurisdictional sections of the securities laws to indicate that the antifraud provisions applied extraterritorially when a version of the conduct-and-effects test is met. That test had been used by the Circuit Courts prior to Morrison to determine if the courts had jurisdiction to consider an extraterritorial transaction. Its application was rejected as unnecessary in Morrison.

Recently the Tenth Circuit sought to harmonize Section 929(p) in SEC v. Scoville, No. 17-4059 (10th Cir. Jan. 14, 2019). There the Court concluded that the Dodd-Frank provision extended the reach of section 10(b) based on an application of the traditional conduct-and-effects test.

Factual background

Scoville centers on what is alleged to have been a Ponzi scheme operated by Defendants Charles Scoville and Traffic Monsoon, LLC, his controlled entity. Traffic Monsoon offered investors two ways to make money. Through its website, maintained on several U.S. based servers, would-be investors could become a member of Traffic Monsoon by paying a small fee and then purchasing one of several different advertising services. Alternatively, the potential investor could purchase an Adpack which entitled the member to receive 1,000 visits to the website and twenty clicks on an internet advertisement, supposedly a $10.95 value. In return the investor obtained the opportunity to share in the ad revenue up to a maximum amount of $55. There was no limit to the number of Adpacks that could be purchased. About 99% of the purchasers qualified to obtain some of Traffic Monsoon’s revenue. Alternatively, members could earn money by recruiting other members.

Adpacks were very popular. Over a two year period, beginning in October 2014, Traffic Monsoon was paid $173 million in new money to purchase about 14 million Adpacks. Members were paid about $2.9 million during the period. About 90% of the members who purchased Adpacks lived outside the United States, generally in poor countries such as Bangladesh, Venezuela and Morocco.

The district court initially entered an asset freeze order and appointed a receiver at the request of the SEC. Following an evidentiary hearing the court entered a preliminary injunction and rejected a claim that the receivership be set aside. The central question on appeal was the extraterritorial reach of section 10(b). The Tenth Circuit affirmed the ruling of the district court.

The opinion

The Circuit Court used a two-prong analysis to reach its conclusion. Extraterritorial reach is in the first instance a question of Congressional intent, the Court noted. In Morrison the Supreme Court stated that the statute only applies within the United States unless there is affirmative and unmistakable evidence that Congress intended otherwise. Stated differently, if there is no clear indication of extraterritorial reach, there is none.

In this case Congress has spoken. Section 929(p) states that “The district courts of the United States . . . shall have jurisdiction of an action or proceeding brought or instituted by the Commission. . . alleging a violation of ” Exchange Act section 10(b). The language of the section is clear.

The fact that Congress intended to extend the reach of the two antifraud provisions in certain circumstances is bolstered by considering the context. Morrison rejected the conclusion that section 10(b) could have extraterritorial effect based on the application of a conduct-and-effects test because “Congress, in originally enacting section 10(b) did not address whether that provision applied extraterritorially.” Other provisions addressed the jurisdictional question. “But Congress, in the Dodd-Frank Act, amended only the jurisdictional sections of the securities laws to indicate that the antifraud provisions applied extraterritorially when a version of the conduct-and effects test is met,” the Scoville Court stated.

Section 929(p) was intended to give the antifraud provisions extraterritorial effect according to the Tenth Circuit: “Notwithstanding the placement of the Dodd-Frank amendments in the jurisdictional provisions of the securities acts, given the context and historical background surrounding Congress’s enactment of those amendments, it is clear to us that Congress undoubtedly intended that the substantive antifraud provisions should apply extraterritorially when the statutory conduct-and effects test [in Dodd-Frank] is satisfied,” the Court held. The point is bolstered by the fact that the title of the provision states it is intended to strengthen the authority of the SEC.

Under the circumstances of the this case the Court found that the statutory test had been satisfied. That test requires that “(1) the conduct within the United States constitutes significant steps in furtherance of the violation . . . [and] (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” Here Mr. Scoville conceived and created Traffic Monsoon in the U.S. The servers were also in this country. The district court concluded this conduct was sufficient to meet the requirements of section 929. The Circuit Court agreed.

Comment

The question presented by Scoville centers on the impact of the Dodd-Frank.Scoville concluded that the clear intent of Congress, evident from a review of legislative materials, dictates that the Dodd-Frank be read to extend the reach of the antifraud provision. That is consistent with Congressional intent.

Ultimately the question may be considered by the Supreme Court. An increasingly conservative Court will no doubt be troubled by the decision in Scoville. In recent securities cases Justices Thomas, Alito and Gorsuch have been critical of majority opinions which cited legislative materials to support a reading of statutory text, arguing that only the text should be considered. See, e.g., Digital Realty Trust, Inc. v. Sommers, 138 S.Ct. 767 (2018)(Thomas, J. concurring in result). At the same time if those materials are ignored Dodd-Frank section 929(p) will be rendered meaningless, a conclusion which is not favored by standard tenants of statutory construction. In the end, the Court might just direct Congress to go back to work and redraft the statute. See, e.g., McNally v. U.S., 483 U.S. 350 (1987)(vague honest services fraud statute required Congressional clarification).

Program: Save the Date of March 19, 2019 for: “Women in Compliance” held at Dorsey & Whitney LLP, 51 West 52nd St. New York, New York, 10019-6119. The program begins at 6:00 p.m. and is followed by cocktails. The announcement is here.

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