by T. GormanPosted on Posted in SECActions

The SEC prevailed in one court case this week but lost in another. In an investment fund fraud action the agency won at trial. In the First Circuit, however, it lost in an appeal of the long running action against two former State Street Bank executives.

Broken windows continued with week with the filing of fourteen administrative proceedings. Seven were against either audit firms or individual accounts, suspending them from practice before the Commission for failures and misconduct in connection with audits. Seven were against either lawyers or their firm for acting as unregistered brokers in connection with EB-5 programs.

SEC

Remarks: Chair Mary Jo White delivered the Keynote Address at the 2015 AICPA National Conference, titled “Maintaining High-Quality, Reliable Financial Reporting: A Shared and Weighty Responsibility,” Washington, D.C. (Dec. 9, 2015). Her remarks discussed the responsibility of auditors and audit committees as well as standard setters and regulators (here).

CFTC

Testimony: Chairman Timothy G. Massard testified before the House Committee on Financial Services (Dec. 8, 2015). His testimony focused on the agenda, structure and operations of the Financial Stability Oversight Council (here).

SEC Enforcement – Litigated Actions

Investment fund fraud: SEC v. National Note of Utah, Civil Action No. 2:12-cv-00591 (D. Utah). Defendant National Note is one of a complex of entities controlled by Wayne Palmer, also a defendant in the action. Investors were solicited in two offerings. Prior to 2007 an offering of unregistered notes was conducted. It raised about $50 million. Beginning in September 2007 a private placement of notes under Rule 506 of Regulation D raised another $50 million. Some of the investors were accredited, some were not. Generally, investors were solicited to purchase notes of National Note. Investors were told that the notes would pay 12% interest and that they were secured by the real estate holdings of several related entities. Investor funds were supposedly loaned to the related entities for investment. The interest payments were guaranteed, according to the sales pitch. Investor funds were supposedly secured by interests in real estate. Some investors were provided with glossy marketing materials which largely reiterated these claims. They were false. In fact investors were being paid from funds received from others. By 2011 National Note had difficulty raising additional capital. Payments to investors dwindled. While promises of repayment were made, the payments were not made. The SEC’s complaint alleged violations of Securities Act Sections 5(a), 5(c) and each subsection of 17(a), in addition to violations of Exchange Act Sections 10(b) and 15(a). A temporary freeze order was obtained by the Commission at the time of filing.

Following a trial the court found in favor of the SEC. The court concluded Mr. Palmer had promised over 600 investors a guaranteed return of 12% while assuring them that their funds were safe. The Court also found that he had deposited investor funds in one account titled “investor trust account,” wired the funds to a second tilted “investor interest account,” and made payments of returns from the funds of other investors. The Court ordered Mr. Palmer to pay disgorgement of $1,767,287.10. National Note was directed to pay disgorgement of $65,188,83. Mr. Palmer was also ordered to pay a penalty of $1,050,000 while National Note will pay $900,000. See Lit. Rel. No. 23419 (December 4, 2015).

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 2 civil injunctive cases and 14 administrative proceeding, excluding 12j and tag-along proceedings.

Auditing: In the Matter of Peter Messineo, CPA, Adm. Proc. File No. 3721 (Dec. 10, 2015) is one of seven actions involving five accountants and two audit firms, each of which was suspended from appearing or practicing before the SEC as accountants for, at various times, performing deficient audits of public companies, jeopardizing the independence of other audits and falsifying and backdating audit documents.

Offering fraud: In re Covenant Partners, L.P., Bankruptcy No. 14-17568 (E.D. Pa.) is a an action previously brought as an administrative proceeding against Covenant Partners, L.P., William Fretz, John Freeman and unregistered investment adviser Covenant Capital Management Partners, L.P. The action centered on the sale of interests through the adviser in a private equity fund. Rather than invest the funds Respondents diverted the funds to their personal use. In resolving the case the investment fund, jointly and severally with the other Respondents, will owe the SEC about $5.8 million which will be distributed to harmed investors. See Lit. Rel. No. 23423 (Dec. 8, 2015).

Fraud: SEC v. Skilling, Civil Action No. 4-00284 (S.D. TX.) is an action against former Enron president and COO Jeffrey Skilling. The Commission concluded its case against Mr. Skilling, obtaining a judgment based on collateral estoppel tied to his criminal conviction and non-opposition to the motion. The judgment is based on violations of Exchange Act Sections 10(b) and 13(b)-5. The court also entered a permanent officer and director bar. See Lit. Rel. No. 23422 (Dec. 8, 2015).

Pyramid scheme: SEC v. Gilmond, Civil Action No. 3:15-cv-00591 (W.D.N.C. Filed December 4, 2015). This action names as a defendant Trudy Gilmond and centers on ZeeksRewards which traces to 2010 when Paul Burks and others created Zeekler.com as a penny auction website. While not that successful, Mr. Burks and his company, Rex Venture Group, LLC, and others launched ZeekRewards in January 2011. The new program was a private, invitation only affiliate advertising division of Zeekler. It was a multi-level marketing program that offered subscription memberships to affiliates. Those recruited then brought in other new affiliates and purchased and gave away samples or sold packages of bids for the penny auction website. Ms. Gilmond was a network marketer who participated in a number of multi-level marketing programs. She operated a full time business soliciting new affiliates and helping her recruits solicit others. No effort was made to determine the financial wherewithal to invest, or the experience level of, customers. Over a period of about one and a half years, beginning in January 2011, the firm raised about $850 million through the offer and sale of securities through the Retail Profit Pool and the Matrix to approximately one million domestic and international investors. In fact ZeeksRewards was as a fraudulent scheme. The average 1.5% daily dividend to Qualified Affiliates was selected to sustain the false impression that the business had returns of 125% every 90 days. Profits from the penny auctions were miniscule and the daily awards could only be supported by funds from others. From her efforts Ms. Gilmond received $461,964 in Matrix commissions and $1,300,074 in daily dividend payments and bonuses based on her purchases and compounding payments in the Retail Profits Pool. Although ZeeksRewards paid out hundreds of millions of dollars, by July 2012 it had insufficient deposits to satisfy future awards. The scheme was thus nearing collapse by the time it was shut down in August 2012. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 15(a). The case is pending. See Lit. Rel. No. 23421 (December 8, 2015).

Offering fraud: SEC v. Feng, Civil Action No. 2:15-cv-09420 (C.D. CA. Filed December 7, 2015). The defendants in the action are attorney Hui Feng and his firm, Law Offices of Feng & Associates P.C. Defendants began promoting the EB-5 program in 2010. Typically, Mr. Feng wrote retainer agreements with clients requiring the payment of legal fees. Defendants recommended clients invest in the offerings of at least five different EB-5 promoters. Commissions were paid by the promoters that ranged from $15,000 to $70,000 per transaction. In addition, if the clients petition was approved the firm was paid additional compensation. Neither Mr. Feng nor his firm disclosed to their clients that they were paid commissions from the promoters. Likewise, the conflict of interest this presented was not disclosed, although if clients specifically inquired they were told. Beginning in May 2013 some promoters told Mr. Feng that they would not wire commissions to a U.S. bank, apparently to avoid the prospect of unregistered broker issues. Mr. Feng circumvented this prohibition by using nominees to whom the payments were made but who secretly acted on his behalf. The representations to the promoters were thus materially false. From March 2011 through April 2015 Defendants or their nominees received at least $1.1 million in commissions from the five promoters and are owed additional fees. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). The action is pending. See, e.g., In the Matter of Kefei Wang, Adm. Proc. File No. 3-16987 (December 7, 2015)(This is one of seven Section 15(a) actions settled by an attorney or the firm in which the attorney effectuated transactions in EB-5 securities, acting as a liaison between the program investment officers and investors and received transaction based compensation; settled with a cease and desist order and the payment of disgorgement and prejudgment interest).

Circuit courts

Flannery v. SEC, Nos. 15-1080 & 15-1117 (1st Cir. December 8, 2015) is an action brought against former State Street Bank and Trust Company employees John Flannery, formerly the chief investment officer, and James Hopkins, formerly the vice president and head of North American Product Engineering. The Order alleged violations of Exchange Act Section 10(b) and Securities Act Section 17(a). It centered a series of claimed false statements made by the two men that supposedly mislead investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management. As a result of those false and misleading statements investors continued to purchase shares in the funds or maintain their positions as the market crisis unfolded and the sub-prime market unraveled. Following a hearing the ALJ dismissed all the charges. The Commission reversed in a 3-2 decision, finding that Mr. Flannery violated Section 17(a)(3) since he was responsible for two misleading letters. The agency also concluded that Mr. Hopkins violated both sections cited in the Order because he was responsible for one false slide that had not been updated in a deck of 20 used in client presentations.

The circuit court reversed, concluding that the SEC’s decision was not supported by substantial evidence as required by the APA. The materiality of the misstatements on the slide – the court assumed for this decision that it was false – was marginal at best, thus belying a finding of scienter. One of the two letters the SEC alleges were false as to Mr. Hopkins had been misread by the agency, and in any event, at oral argument counsel admitted that it did not contain false statements.

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by T. GormanPosted on Posted in SECActions

The long ordeal of two former employees of State Street Bank and Trust Company appears to have come to an end. Initially charged by the SEC with making false statements in the mist of the market crisis, the Administrative Law Judge found against the Division and dismissed the charges based largely on an application of the Supreme Court’s decision in Janus.

The Commission reversed in a 3-2 decision, concluding that James Hopkins, formerly the vice president and head of North American Product Engineering, had made one false statement in one slide used for presentations and had thus violated Securities Act Section 17(a)(1) and Exchange Act Section 10(b). John Flannery, formerly the chief investment officer, was responsible for two misleading letters and thus violated Securities Act Section 17(a)(3). Those decisions were reversed by the First Circuit Court of Appeals. Flannery v. SEC, Nos. 15-1080 & 15-1117 (1st Cir. December 8, 2015).

Background

The initial proceeding centered a series of claimed false statements made by the two men that supposedly mislead investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management. As a result of those false and misleading statements investors continued to purchase shares in the funds or maintain their positions as the market crisis unfolded and the sub-prime market unraveled.

According to the Order, by 2007 the fund was almost entirely invested in, or exposed to, the subprime market. The Respondents, however, continued to describe it in various materials and statements as having better sector diversification than a typical money market fund. They failed to inform investors about the extent of its exposure to sub-prime investments. Offering materials for the fund such as quarterly fact sheets, presentations to current and prospective investors, and responses to investor requests for proposal were misleading because they omitted material about the exposure of the fund to the sub-prime market. Mr. Hopkins was responsible for these materials the Order alleged.

A series of shareholder communications were also false and misleading because they failed to inform investors about the fund’s concentration in subprime. Messrs. Hopkins and Flannery played an instrumental role in drafting the misrepresentation in these communications, according to the Order.

As the market crisis evolved State Street’s internal advisory groups decided to redeem or recommend redemption from the fund for their clients. State Street Corporation’s pension plan was one of those clients. Mr. Flannery and the investment committee sold the fund’s most liquid assets and use the cash to redeem shares for what the Order calls “better informed” investors. The fund was left with largely illiquid holdings. The Order alleged violations of Sections 17(a) and 10(b).

Circuit court

The circuit court decision turns the question of whether there was substantial evidence to support the findings of the Commission as well as questions of materiality. The slide was part of a presentation used by Mr. Hopkins for potential investors. It contained a number of statistic regarding assets classes and was labeled Typical Portfolio – it did not represent any one fund but provided a general overview. At the time of the presentation in question Mr. Hopkins had not updated the concentration numbers on the slide which would have shown an increase in ABS held.

In reviewing the Commission’s finding the court assumed that the Typical Portfolio slide was misleading. The court also assumed that Mr. Hopkins used the slide in his presentations. But in view of the totality of the facts which demonstrated that the slide was just one of 20, that update information was available and that the slide was actually a generic and not representative of any specific fund the court concluded that “This thin materiality showing cannot support a finding of scienter. . .” Indeed, Mr. Hopkins testified that in his experience investors did not focus on sector breakdown when making their investment decisions and there was no contrary evidence. Accordingly, the SEC’s determination was found not to be supported by substantial evidence.

The court reached a similar conclusion as to Mr. Flannery. The determination focused on two letters that the SEC found misleading when when considered together because they encouraged investors to hold their shares even though the firm’s own funds and internal advisory group clients were selling.

The court concluded that the first letter was not misleading even when considered with the second. The SEC focused on an assertion in the first letter that the sale of certain AAA rated securities did not reduce the risk of the fund. The Commission claimed this was false because it left lower grade securities thus increasing the risk. Expert testimony established otherwise based on the overall composition of the portfolio.

Perhaps more importantly, “the Commission has misread the letter,” according to the circuit court. And, at oral argument counsel for the SEC acknowledged that no specific sentence in the letter was inaccurate.” Since the first letter was not inaccurate, and one incorrect statement is not sufficient to violate Section 17(a)(3), the court did not analyze the second. Ultimately the court concluded that “We do not thin the letter was misleading and we find no substantial evidence supporting a conclusion otherwise.”

Comment

The reversal of the SEC’s conclusions here for a lack of evidence is a substantial set-back for the agency. Frequently the SEC defends these types of actions asserting that Chevron deference is due to its legal positions, effectively insulating them from review, and that its findings of fact are protected by the substantial evidence requirement of the Administrative Procedure Act. It is rare for a court to second-guess the determinations of the agency in view of these standards, particularly on the evidence. The loss here, coupled with the history of the action, more that suggests over-reaching by the SEC. Perhaps in the future more careful consideration will be given to be given to enforcement decisions before persons are forced to face the years long ordeal of an enforcement action.

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