by T. GormanPosted on Posted in SECActions

Having the correct compliance procedures in place can often be critical. The SEC and the DOJ have repeatedly emphasized this in FCPA cases. Conducting due diligence can be equally critical. For gatekeepers such as lawyers, accountants and brokers, conducting appropriate due diligence can mean the difference between preventing a violation and becoming entangled in it. That was the result for two E*Trade subsidiaries who sold millions of shares of microcap stocks that were not registered despite representations to the contrary from their clients. In the Matter of E*Trade Securities, LLC, Adm. Proc. File No. 3-16192 (October 9, 2014).

From March 2007 through April 2011 the two E*Trade subsidiaries named at Respondents at various times facilitated the sale of millions of unregistered microcap shares for three Customers, according to the Order. Customer A opened an account with E*Trade in early 2007; Customer B opened an account later that year; and Customer C opened an account in March 2010. The Customers are institutional clients.

During the period the three Customers routinely acquired large quantities of newly issued penny stocks in private offerings. The Customers represented to E*Trade that the stocks were acquired in PIPE offerings. The size of the deposits varied from several thousand shares to a billion. The shares were issued by 247 companies. Generally the shares were resold within a short period. There were no registration statements on file with the Commission for the shares.

Respondents did not ask Customers A and B to identify the specific exemption from registration relied on. Likewise, the two Customers were not asked for documentation regarding any exemption. Rather, the two subsidiaries made the following inquiries:

  • What was the intended trading activity;
  • Customer A was asked for written representations that the shares were freely tradable;
  • Customer A furnished written representations that it would comply with the applicable law;
  • Respondents visited the offices of both customers several times to determine that they were reputable;
  • Beginning in March 2009 Respondents reviewed pending deposits to determine if they had financial risk; and
  • In November 2009 the trading history of both Customers was reviewed.

From March 2010 through April 2011 “Enhanced Due Diligence” was conducted regarding share deposits for Customers A and C. Under this process written representations were obtained from the Customer and issuer that the shares were freely tradable. Opinions from attorneys were also obtained that were based largely on representations from the reseller and issuer. Respondents also researched the attorneys.

These procedures were inadequate, according to the Order. While Securities Act Section 4(a)(4) exempts from registration brokers’ transactions, it is unavailable when the broker knows, or has reasonable grounds to know, that the shares are not exempt. To rely on the exemption a reasonable inquiry must be conducted. The scope of that inquiry depends on the surrounding facts and circumstances.

Here Customers A, B and C were continually faced with a series of red flags which should have raised a question as to whether they were engaged in an illegal distribution: 1) each acquired substantial amounts of newly issued penny stocks; 2) those shares were acquired from little known, non-reporting issuers; 3) they were acquired through private unregistered transactions; 4) the shares were immediately resold; and 5) the funds were wired out. Nevertheless, Respondents failed to conduct the kind of searching inquiry that was required under the circumstances. Accordingly, Respondents willfully violated Securities Act Sections 5(a) and 5(c).

To resolve the proceeding each Respondent consented to the entry of a cease and desist order based on the Sections cited and to a censure. On a joint and several basis Respondents will pay disgorgement of $1,402,850, prejudgment interest and a penalty of $1 million.

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by T. GormanPosted on Posted in SECActions

The Commission prevailed in an investment fund scheme action, obtaining a favorable summary judgment ruling. In reaching its conclusion the Court rejected claims that the action was time barred and that the cause of action was outside the scope of Exchange Act Section 10(b). SEC v. Funinaga, Civil Action No. 2:13-CV-1658 (D. Nev. Order entered Oct. 3, 2014).

The SEC named as defendants Edwin Yoshihiro Funinaga and MRI International, Inc. The complaint alleged an investment fund fraud which began in 1998, and continued through 2013, in which over $800 million of investor funds were raised. Those investors were largely in Japan.

Investors were told that the firm purchased medical accounts receivables at a discount. Full value would be realized from the insurance companies. Investors were assured that their funds were safe because of the “role of state governments” which provided guarantees through the deposit system. Investor funds were supposedly kept in “special lock box accounts” managed by an escrow agent.

In fact the defendants were operating a Ponzi scheme, according to the complaint. Investors were repaid with funds raised from other investors. The supposed escrow agent claimed the funds were transferred to Mr. Funinaga. In a statement to the Japanese Financial Services Agency, Mr. Funinaga admitted that investor funds were used to repay other investors. Other portions of the investor funds were diverted to the personal use of Mr. Funinaga who invoked his Fifth Amendment rights in the action.

In considering a series of motions the Court initially rejected defendants’ claim that it lacked subject matter jurisdiction based on the application of 28 U.S.C. Section 2462, the five year statute of limitations. The SEC opposed this motion, claiming that the cause of action continued until 2013 and, in any event, the statute does not apply to equitable remedies. Following SEC v. Ring, 991 F. 2d 1486 (9th Cir. 1993) the Court concluded that the statute of limitations does not apply to disgorgement claims. While other jurisdictions have applied Section 2462 to all forms of relief, Ring is controlling here.

Second, the Court rejected a claim that the action should be dismissed under Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010) which held that a cause of action under Exchange Act Section 10(b) does not have any extraterritorial application. While the SEC claimed that Morrison had been overruled for government enforcement actions by Dodd-Frank, the Court did not reach that issue. The Court noted that other jurisdictions have found a “lack of clarity” on this point, citing. SEC v. Chi. Convention Ctr., LLC, 961 F. Supp. 2d 905, 916-17 (N.D. Ill. 2013). Rather, the Court concluded that the securities transactions involved here closed and title was transferred in Nevada. That is sufficient under Morrison the Court found.

Finally, the Court concluded that there was sufficient evidence to grand summary judgment in favor of the SEC. Here the evidence demonstrates that the defendants made material misrepresentations regarding the investments. Mr. Funinaga had sole control over the investment fund and used the cash for his personal benefit. His control over the scheme, use of the funds, misrepresentations regarding the safety of the funds, when coupled with his assertion of the Fifth Amendment are sufficient to establish the key elements of a claim. Defendants’ attempt to refute the evidence of the SEC by claiming that the Court does not have jurisdiction is not sufficient. Accordingly, summary judgment was entered in favor of the Commission. See Lit. Rel. No. 23111 (October 10, 2014).

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