by T. GormanPosted on Posted in SECActions

The D.C. Circuit rejected efforts by the SEC to compel the Securities Investor Protection Corporation to liquidate a broker-dealer that was part of the Stanford Ponzi scheme empire. The investors had purchased CDs from an off-shore Stanford entity. The Circuit Court affirmed the decision of the District Court. SEC v. SIPC, No. 12-5286 (D.C. Cir. Decided July 18, 2014).

The case arose out of the massive financial fraud authored by Robert Allen Stanford. At the center of the scheme the SEC has called a Ponzi scheme, was a complex web of entities. Two are involved here. One is the Stanford International Bank, Ltd. or SIBL, a bank organized under Antiguan law. It sold debt assets that promised a fixed rate of return. The second is Stanford Group Company or SGC, a Huston-based broker-dealer registered with the SEC.

To purchase a CD, investors had to open an account with SIBL, according to the factual record which was largely stipulated. CD purchasers paid the bank for the instruments. The U.S. disclosure statements stated that SIPIC did not provide coverage for the CDs.

In 2009 the SEC brought a civil enforcement action against Mr. Stanford, SGC, SIBL and others. The court appointed a receiver for SGC and other entities. The receiver concluded that the bank had outstanding about $7.2 billion in CDs. The receiver asked SIPC to determine if it would liquidate SGC to protect the assets of those who had purchased CDs from SIBL. SIPIC determined that those investors were not covered. Eventually, the SEC prevailed in its case and imposed a $6 billion civil penalty. Mr. Stanford was convicted on criminal charges and sentenced to serve 110 years in prison. Antiguan authorities initiated separate proceedings to liquidate SIBL and process claims. Other civil litigation was initiated.

Two years later the SEC concluded SIPIC was wrong as to the SIBL issued CDs. It filed an application with the District Court to compel SIPC to commence liquidation proceedings. SIPIC declined. The District Court concluded that SIPIC was correct in determining that the CD purchasers were not customers within the meaning of the Act, a prerequisite to coverage. The District Court rejected the request for an order to compel SIPIC.

The critical question here, according to the Circuit Court, is whether those who purchased SIBL CDs at the suggestion of the broker-dealer are customers for purposes of the Securities Investor Protection Act. That Act, passed in 1970, created SIPIC to provide relief to customers of failing broker-dealers. When a SIPC member firm is in financial difficulty the non-profit corporation can initiate a liquidation proceeding in which a trustee can be appointed to oversee the liquidation of the firm after removal to bankruptcy court. The trustee is to return any customer cash and securities on deposit with the broker. If there are insufficient funds, SIPIC must cover the shortfall up to certain limits. The SEC has plenary authority to supervise SIPIC.

The Securities Investor Protection Act focuses on the custody function of brokers. It provides coverage for customer funds and securities held on deposit with the broker which, prior to the Act, were often depleted in the liquidation of the firm. The Act generally affords no protection against other types of losses.

A customer is generally defined as a person who has deposited cash with the broker for the purpose of purchasing securities. A claimant must generally demonstrate that the broker received or held the claimant’s property and that the transaction gave rise to the claim and contained the indicia of a fiduciary relationship between the customer and the broker.

In this case the purchasers of SIBL CDs are not customers within the meaning of the Act, the Court held. It is undisputed that the investors did not deposit cash with SGC. Since “SGC had no custody over the investors’ cash or securities, the investors do not qualify as SGC ‘customers’ under the ordinary operation of the statutory definition” the Court concluded.

The SEC argued, however, that given the interrelation of the Stanford entities, funds deposited with SIBL should be viewed as effectively on deposit with SGC – the entities should be viewed as one. This theory is grounded on the bankruptcy doctrine of “substantive consolidation” which, under equitable principles, would view the entities as one.

While that doctrine may be applicable here, it does not support the SEC’s contention. The SIPIC statute excludes from coverage investments in the debtor which add to its capital, the Court stated. Thus, even if the entities are viewed as one, since the CDs are a contractual investment in the entity which added to the capital of SIBL, they are excluded. While the SEC attempted to side-step this result by arguing that the CD proceeds became part of the capital of SIBL and not the broker dealer, if the entities are merged the funds become part of the capital of the merged entity.

Finally, in its reply brief the SEC claimed for the first time that funds given to a consolidated entity for the CDs should not become part of the entity’s capital because they were part of a Ponzi scheme. The SEC offered no authority for this contention which was rejected by the Court. The fact is the CD purchasers acted as lenders which are not covered. While the plight of these investors is unfortunate, the Court noted, they are not covered by the statute.

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by T. GormanPosted on Posted in SECActions

Microcap fraud is a continuing enforcement priority for the SEC. Last week, for example, the Commission brought an action centered on what would have been a pump and dump scheme but for the fact that the shell company was controlled by an FBI informant and the SEC stepped in at the last moment and suspended trading.

Now the agency has brought an action centered on microcap fraud schemes tied to a repeated fraudster, SEC v. Plummer, Civil Action No. 14 CV 5441 (S.D.N.Y. Filed July 18, 2014). The action names as defendants: Christopher Plummer, the CEO of Franklin Energy and Madison & Wall Investments, LLC, who has two prior convictions for fraud based offenses and is currently serving 51 months in prison following his guilty plea to fraud charges in another, unrelated case; Lex Cowset, the CEO of CytoGenix, Inc., a microcap pharmaceutical company; and GyroGenix.

The first scheme centers on Company A and Mr. Plummer. Company A portrayed itself as a security company that used technology such as encryption software and video surveillance systems for actionable surveillance and intelligence monitoring.

In 2009 Company A announced that it would focus on renewable energy and medical testing using nanotechnology. Subsequently, the firm announced that it was also developing solar energy farms through a joint venture with Franklin Energy, a subsidiary of Franklin Power & Light LLC, a retail electricity provider purportedly operated by Mr. Plummer. The joint venture was to build, own and operate solar energy farms across the United States beginning as early as the latter part of 2010.

A series of press releases and web site postings were made touting Company A and the potential of the joint venture. In fact neither Franklin nor Company A had the resources that were claimed in the press releases. There were no resources to implement the plans of the joint venture. Nevertheless, the press releases and web postings had a significant market impact, according to the complaint.

A second scheme involved CytoGenix. Prior to its affiliation with Mr. Plummer the company held it self out to be a developer of biotechnology derived products for vaccines and therapeutic applications for human, agricultural and veterinary markets. In 2010 Mr. Plumber approached the firm about a partnership with Franklin. After Mr. Cowsert agreed a press release dated August 16, 2010 was issued. It announced the formation of a company subsidiary called BioEnergy that would operate as a joint venture partner with Franklin. The venture would be run by Mr. Plumber. Its purpose was to identify, evaluate and develop biologically based technologies for energy production.

In the Fall of 2010 CytoGenix sold private placement shares tied to its partnership with Franklin. About $330,000 was raised through this offering. Investors were told the funds would be used to help develop the joint venture.

In fact the claims about the venture and the entities were false. CytoGenix was financially distressed, having lost all its intellectual property in an earlier litigation, contrary to representations made in press releases about the firm. Franklin was essentially a sham, also contrary to representations made about the company. And, the proceedings of the offering were not used for the purpose told to investors. Indeed, no shares were ever issued to investors and Messrs. Plummer and Cowsert misappropriated the funds. The Commission suspended trading in the shares of CytoGenix in 2011.

The complaint alleges violations of Exchange Act Sections 10(b) and 20(b) and Securities Act Section 17(a). The case is in litigation. See Lit. Rel. No. 23047 (July 18, 2014).

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