This Week In Securities Litigation (Week ending August 28, 2015)
The Sixth Circuit last week concluded that Morrison, which held that Section 10(b) does not have extraterritorial reach, is inapplicable to Advisers Act Section 10(b). The DC Circuit, on rehearing, reaffirmed its prior holding that a portion of the Commission’s Dodd-Frank conflict rules violates the First Amendment.
SEC enforcement prevailed on a summary judgment motion in an action centered on false statements made by an issuer regarding a claimed cancer treatment. In addition, two new offering fraud actions were filed along with an insider trading case and another action centered on the misappropriation of funds in connection with an EB-5 program.
Statement: Commissioner Luis A. Aguilar issued a statement titled Enhancing the Commission’s Waiver Process (August 27, 2015). The statement calls for more transparency in the waiver process and a flexible approach while discussing a process adopted last year regarding conditional waivers (here).
SEC Enforcement — Litigated cases
False statements: SEC v. Cook, Civil Action No. 1:13-cv-01312 (S.D. Ind.) is an action against Timothy Cook, Xytos, Inc. and Asia Equities. The complaint alleged that beginning in 2010 Mr. Cook made materially misleading statements regarding the company, supposedly in the biomedical business, and a claimed cancer treatment. The SEC also alleged that he sold unregistered shares in the firm. In fact there was no treatment. The court granted summary judgment in favor of the Commission, concluding that Mr. Cook violated Securities Act Sections 5(a) and 5(c) and 17(a) and Exchange Act Section 10(b). The court imposed a permanent injunction, an officer and director bar, a penny stock bar and ordered disgorgement in the amount of $642,828. The Court will consider the amount of a civil penalty. Default judgments were entered against the two entities. See Lit Rel. No. 23328 (August 25, 2015).
SEC Enforcement – Filed and Settled Actions
Statistics: During this period the SEC filed 3 civil injunctive cases and 1 administrative actions, excluding 12j and tag-along proceedings.
Offering fraud: SEC v. Schumacher, Civil Action No. 15-6388 (C.D. Cal. Unsealed August 26, 2015) is an action which names as defendants Harrison Schumacher and his two firms, Quantum Energy LLC and Quaneco LLC. Since 2010 the defendants have raised $12.3 million through a series of five offerings from over 300 investors. Those investors were told the funds would be used to explore for and develop oil and gas properties. Instead they were diverted to other uses by the defendants. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b) and 15(a). The case is pending. See Lit. Rel. No. 15-6388 (August 27, 2015).
Insider trading: SEC v. Aggarwal, Civil Action No. 2:15-cv-06460 (C.D. Cal. Filed August 25, 2015). Defendant Ashish Aggarwal worked as an analyst at J.P. Morgan Securities LLC in its San Francisco office. His friend, defendant Shahriyar Bolandian, worked for an e-commerce company founded by Kevan Sadigh, also a defendant in the SEC’s action. Each defendant declined to testify during the staff’s investigation. The case involved trading in two deals. The first involved Integrated Device Technology, Inc. and PLX Technology, Inc. The second involved the ExactTarget, Inc., a provider of email and cloud marketing services, and salesforce.com, Inc., a provider of enterprise cloud computing services. Following the retention of JPM in each instances there were multiple text messages between Messrs. Aggarwal and Bolandian and multiple trades by Mr. Bolandian and Mr. Sadigh. After the first deal announcement Messrs. Bolandian and Sadigh sold their interest in PLXT, yielding, respectively, gains of $36,200 and $41,200. After the second Mr. Bolandian’s accounts had profits of about $317,000. Mr. Sadigh had profits of about $178,000. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is pending. See Lit. Rel. No. 23327 (August 25, 2015).
Offering fraud: In the Matter of Randy E. Olshen, Adm. Proc. File No. 3-16549 (August 25, 2015) is a proceeding naming as a Respondent Mr. Olshen, the founder and President of Innovative Health Solutions, LLC, a sports hydration drinks company. Beginning in 2009 Mr. Olshen is alleged to have implemented a plan to sell unregistered shares in the company using fabricated accounting records. Over $7 million was raised from about 50 investors. The Order alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). To resolve the matter Mr. Olshen consented to the entry of a cease and desist order based on the Sections cited in the complaint. In addition, an order was entered barring him from the securities business and from participating in any penny stock offering. In view of the requirement that he pay restitution in the related criminal matter in which he pleaded guilty, no restitution or penalty was ordered.
Misappropriation: SEC v. Path America, LLC, Civil Action No. 2:15-cv-01350 (W.D. Wash. Filed August 24, 2015). Named as defendants in this action are Lobsang Dargey and seven LLCs he controls including Path America, LLC, Path America SnoCo, LLC and five other similarly named entities. Mr. Dargey also controls the bank account for each entity through with the program funds flowed. The action centers around two projects, the Tower Project and the Farmer’s Market Project. For the Tower Project, beginning in November 2013 Mr. Dargey, Path America and three other controlled entities raised about $85 million from 170 Chinese nationals as investments in real estate developments in Seattle. Investors acquired a limited partnership interest for $500,000 plus an administrative fee of $45,000.For the Farmer’s Market project, beginning in 2012 Mr. Dargey, Path America and other related entities raised about $41 million from 82 Chinese nationals as investments in a residential real estate development in Everett, Washington. The PPM was substantially similar to the one for the Tower Project. Both PPMs were false and misleading, according to the complaint. Both represented that the funds would only be used in accord with the business plans provided to USCIS. In fact they were not. Overall defendants are alleged to have misappropriated about $17.6 million of investor funds. The complaint alleges violations of Exchange Act Section 10(b) and each subsection of Securities Act Section 17(a). The Commission secured an emergency freeze order. The case is pending. See Lit. Rel. No. 23326 (August 25, 2015).
Net capital: The regulator fined Charles Schwab & Co. $2 million and censured the firm in connection with net capital violations between May 15, 2014 and July 1, 2014. The violations arose because on certain dates the inflows of cash to the firm exceeded the amounts it could invest so it made large, unsecured loans to its parent resulting in net capital violations. In doing that the firm failed to consult with its regulatory group, demonstrating a lack of procedures.
Court of Appeals
Extraterritorial reach: Lay v. U.S., Case No. 13-4021 (6th Cir. August 17, 2015). Defendant Mark Lay was a registered investment adviser. He operated two funds, one on shore and the other off shore, in which he invested funds for the Ohio Bureau of Workers’ Compensation. The off-shore fund suffered losses after he leveraged it, contrary to the rules of the Bureau. Although he concealed the losses and the leverage eventually the Bureau found out and withdrew its funds. Only $9 million of its $225 million investment was returned. Mr. Lay was convicted of securities fraud and other charges. He argued, however, that the securities fraud conviction, based on Advisers Act Section 206, was barred by Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010). There the Court held that Exchange Act Section 10(b) did not have extraterritorial reach based on a presumption against such reach absent Congressional intent to the contrary. The Court rejected this contention, concluding that “The problem with defendant’s argument is two-fold: (1) the Securities Exchange Act and the Investment Advisers Act seek to regulate different aspects of securities transactions, and (2) unlike Morrison, the only aspect of this case not tied to the United States is that the fund in question is based in Bermuda. All other aspects of the case are centered in the United States.” In addition, the focus of the Advisers Act is the prevention of wrongful practices by the adviser, the Court determined. This contrasts sharply with the Exchange Act which is centered on the purchase or sale of a security. According, the court concluded that Morrison does not apply to Section 206 of the Advisers Act.
Conflict mineral rule: National Association of Manufactures v. SEC, No. 13-5252 (D.C. Cir. Opinion issued August 18, 2015). This suit challenged the SEC’s conflict minerals rules, written under Dodd-Frank. The initial decision upheld the rules but rejected one provision as contrary to the First Amendment (here). On rehearing by the panel, the result was the same. The rehearing was granted because the en banc court, in another case, reinterpreted the Supreme Court’s decision in Zander v. Office of Disciplinary Counsel of the Supreme Court of Ohio, 471 U.S. 626 (1985) which governed the standard of review in compelled speech cases regarding misleading advertising and broadened it to include labeling for country of origin for meat cuts. That standard is more relaxed than the one applied in the prior decision based on Central Hudson Gas & Electric Corp. v. Public Service Commission, 447 U.S. 557 (1980). Nevertheless, the court refused to apply Zander.
To bolster its decision, the Court added an alternate holding keyed to three points. First, under Central Hudson the court must assess the interest motivating the disclosure requirement. The SEC noted that it is ameliorating the humanitarian crisis in the DRC. This is sufficient. Second, the effectiveness of the measure in achieving that goal must be assessed. The SEC offered little on this point the Court noted. A review of various materials, including the potential costs, lead the Court to conclude that there was little but speculation. “[T]his presents a serious problem for the SEC because . . . the government must not rest on such speculation or conjecture . . . Rather the SEC had the burden of demonstrating that the measure it adopted would ‘in fact alleviate’ the harms it recited . ..” “This in itself dooms the statute and the SEC’s regulations” the Court concluded.
Finally, the Court considered if the compelled disclosures were “purely factual and uncontroversial.” The descriptions of “conflict free” or “not conflict free” are hardly factual and non-ideological. This requires an issuer to tell consumers if its goods are ethically tainted.” “By compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the freedom of speech under the First Amendment.”