This Week In Securities Litigation (Week ending August 5, 2016)
The SEC prevailed on summary judgment in an action centered on an offering fraud. The principals of the scheme were found to have violated the antifraud provisions while a codefendant was determined to have acted as an unregistered broker.
Two new actions were brought this week. One is an insider trading case against a physician who was leading clinical drug trials and traded in the firm’s shares in two instances based on negative news which had not been announced by the company. The second involved an investment adviser suffering financial difficulties who failed to disclose to clients that the shares he was recommending could be purchased at a lesser price without the payment of 12b-1 fees which represented a substantial part of its income.
Update: The Commission, along with the Department of Treasury, the Board of Governors of the Federal Reserve, the Federal Reserve Bank of New York and the CFTC issued a statement outlining their progress on a review of the U.S. Treasury Market Structure, updating the July 2015 staff report (here).
Securities Class Actions
In the first half of 2016 119 new securities class actions were filed. That compares to 87 filed during the same period in 2015. The number of filings eclipses the 94 actions filed on average from 1997 through 2015. The increase is explained, according to the report, by the substantial uptick in the number of M&A class actions. If this trend continues, 2016 will be the first year since 2008 to be above average since 1997and will be the second largest number of filings in one year, exceeded only by the 242 actions brought in 1998. The number of actions brought against NYSE listed firms increased by 2% over the second half of 2015. For NASDAQ firms the increase was 27%. For the first half of the year there were 38 filings in the Ninth Circuit and 36 in the Second.
SEC Enforcement – Litigated Actions
Offering fraud: SEC v. Downey, Civil Action No. 1:14-cv-00185 (N.D. Tex. Nov. 20, 2014). The action was brought against Paul Downey, Jeffry Downey (father and son) and the principals of Quest Energy Management Group, Inc., and John Leonard who acted as a salesman. From January 2010 through May 2011 the father and son sold the preferred stock of Quest and limited partnership units in Permaian Advanced Oil Recovery Investment Fund I, LP, according to the complaint. Investors were told that the LP would acquire working interests in oil and gas leases from Quest and receive revenue from those leases. About $4.8 million was raised from 17 investors. In fact the representations were false. The PPM did not provide accurate financial information or fully describe the use of the proceeds. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a).
The court granted the Commission’s motion for summary judgment as to all defendants but in separate orders. In the order as to the Downey defendants, the court first concluded that the limited partnership interests were securities. The Court went on to find in favor of the SEC on its fraud claims, centered on the sale of the interests. At the time of the sales “there was a receivership involving other entities with which the Downeys were involved (including the operating general partner of the limited partnership), and the Downeys failed to inform investors of the receivership and how it could impact the investors by recovering over five million dollars from the operating general partner.” There were, in addition, other misrepresentations including about the use of proceeds, the court concluded. The court thus found violations of Securities Act Section 17(a) and Exchange Act Section 10(b).
Finally, the court found in a separate order that defendant Leonard acted as an unregistered broker in selling the securities. This is reflected by the over $400,000 in commissions he was paid for selling over $4 million in limited partnership units to 13 investors. He solicited those investors in person, by phone and through emails, recommending the investment. Accordingly, the Court found violations of Exchange Act Section 15(a).
The court established a briefing schedule regarding remedies. See Lit. Rel. No. 23608 (July 29, 2016).
SEC Enforcement – Filed and Settled Actions
Statistics: During this period the SEC filed 1 civil injunctive action and 1 administrative proceeding, excluding 12j and tag-along proceedings.
Insider trading: SEC v. Kosinski, Civil Action No. 3:16-cv-01322 (D. Conn. Filed August 4, 2016) is an action which names as a defendant Edward Kosinski, a cardiologist at St. Vincent’s Medical Center in Bridgeport, Connecticut and president of Connecticut Clinical Research, LLC. In 2014 Dr. Kosinski traded in advance of two announcements by bio-tech firm Regado Biosciences of negative news regarding drug trials for REG-1, a drug to regulate blood clotting for certain patients. Dr. Kosinski received advance notice of news regarding the trials from the manager because he served as principal investigator on the trials. In the first instance he learned that the trials would be suspended; in the second that a patient had died. In the first instance he sold 40,000 shares of Regado stock, avoiding losses of about $160,000 when the company later announced the news. In the second he purchased put options prior to the announcement. Following the announcement he had a gain of about $3,291. The complaint alleges violations of Exchange Act Section 10(b) and Securities Act Section 17(a). The case is pending. The U.S. Attorney’s Office for the District of Connecticut announced parallel criminal charges.
Conflicts: In the Matter of Alison, LLC, Adm. Proc. File No. 3-17365 (August 2, 2016) is a proceeding which names as Respondents the firm, a registered investment adviser, and its founder and sole owner, Stephen Alison. The Order alleges that beginning in 2011, and continuing through 2014, the adviser failed to disclose its difficult financial circumstances as required by Form ADV despite the fact that the firm could not make payroll, pay its payroll taxes or pay the required rent. During the period the adviser made sums ranging from a low of just over $23,000 to as much as $85,000 from 12b-1 fees. Those fees equaled 8.3% to 12.9% of the advisory fees. The 12b-1 fees were ultimately paid out of client assets. Clients were not told that cheaper share classes were available which did not pay the fees but had identical holdings. Finally, the adviser failed to produce books in records as requested during a staff examination. The Order alleges violations of Advisers Act Section 204(a). The proceeding will be set for hearing
Insider trading: SEC v. Andrade, Civil Action No. 15-cv-231 (D.R.I.) is a previously filed action which named as defendants Anthony Andrade, a member of the board of directors of Bancopr Rode Island, Inc., and three of his friends – Kenneth Rampino, Robert Kielbasa and Fred Goldwyn. The complaint alleged that Mr. Andrade told his friends about the then future acquisition of the bank and that each traded, reaping profits of over $80,000. Messrs. Kielbasa and Goldwyn settled at the time the complaint was filed in June 2015. The court entered a final judgment against Mr. Rampino, enjoining him from future violations of Exchange Act Section 10(b) and directing that he pay disgorgement of $18,959, prejudgment interest and a penalty equal to the amount of the disgorgement. The action is continuing as to Mr. Andrade. See Lit. Rel. No. 23609 (July 29, 2016).
Reporting violations: The regulator fined Barclays Capital Inc. $1.3 million for repeated and extensive OATS reporting violations and related supervisory failures. Firms are required to transmit to OATS complete and accurate data relating to orders, called ROEs. Barclays Capital had systems issues that resulted in the transmission of over 3 billion inaccurate or incomplete ROEs to OATS. Those included omitting special handling codes, inaccurate timestamps, and similar items.
Churning: The regulator charged registered representative Hank Werner with defrauding a 77 year old widow by churning her account. Specifically, Mr. Werner had been the account executive of the widow and her now deceased husband since 1995. Following the husband’s death the representative began aggressively trading the account, placing over 700 trades in over 200 different securities between October 2012 and December 2015. He charged her a mark-up or commission on each transaction. When he charged firms, the representative increased the charge to his client. Overall he generated about $243,000 in commissions while causing $184,000 in losses. The complaint alleges that there was little possibility that the trades could have been profitable. The complaint also alleges that the trades were not suitable. The case is pending.
Insider trading: U.S. v. McPhail, No. 15-2106 (decided July 26, 2016). This action and its companion case, U.S. v. Parigian, No. 15-1994, 2016 WL 3027702 (1st Cir. May 26, 2016), arise from the same factual background, centered on a group of golf friends. Eric McPhail is a tile salesman. He became friends with Angelo Santamaria, an executive at American Superconductor Corporation. After meeting at a country club in 2007 the two men became fast friends, traveling together and frequently socializing. During their conversations Mr. Santamaria frequently talked about his firm, its prospects and the stock price – a topic with which he was pre-occupied because his retirement account held a substantial block of firm stock. On at least two occasions the men discussed the fact that the business information was never to be repeated.
Mr. McPhail did not maintain the confidence. He communicated the information orally and in emails to a group of golfing buddies, including Mr. Parigian. The buddies traded, reaping nearly $500,000 in profits. Mr. McPhail did not trade.
Mr. McPhail’s conviction by a jury on insider trading was affirmed by the First Circuit. Two issues were key on appeal, one regarding SEC Rule 10b5-2(b)(2) and the other focused on the Dirks v. SEC, 463 U.S. 646 (1983) personal benefit test. First, in assessing the application of the misappropriation theory of insider trading the court focused on whether there was a relationship of trust and confidence between the two men which was breached. The issue focused in part on the SEC Rule which defines a duty of trust and confidence, requiring that “the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality.” A critical question is whether the “knew or should have known” standard conflicts with the proof requirements in criminal cases. In Parigian the court noted that this was an open issue, although two cases contain dicta suggesting the Rule is valid. In McPhail the court discussed the point but again declined to resolve it, finding the issue had been waived by a failure to object to the instructions.
Second, the court considered the Dirks personal benefit test. Mr. McPhail argued that there was a failure of proof on this question. In addressing this issue the court noted that Mr. McPhail was “[a]ssuming that this principle extends to tippers in misappropriation cases . . .” raising, but not deciding, an issue that was rejected by Newman. Following its approach from Parigian, the court then applied the 2006 panel decision in SEC v. Rocklage, 470 F. 3d 1 (1st Cir. 2006) rather than analyzing the later decided Second and Ninth Circuits in, respectively, U.S. v. Newman, 773 F. 3d 483 (2nd Cir. 2015) and U.S. v. Salaman, 792 F. 3d 1087 (9th Cir. 2015) which is now pending before the Supreme Court. Under that standard the court concluded that personal benefits of 1) a free dinner, wine and a massage parlor visit and 2) a payment from his grateful buddies of $3,000 was sufficient.
Credit lined notes: BaFin, the Federal Financial Supervisory Authority, announced plans to ban credit-linked notes. The regulator noted that these instruments were very complex noting that the interest and repayment of the investment depends on the credit risks of referenced entities. Of particular concern is when the credit event relating to the underlying referenced liability will occur which retail clients typically cannot evaluate.
Suspicious trading: The Securities and Futures Commission found after an investigation that Ko Cho Ting placed suspicious trades at the direction of a client for over two years. Specifically he repeatedly placed orders for the shares of Timeless Software Limited from May 1 to June 28, 2012 during the last two minutes of the Continuous Trading Session on 18 trading days. During the period 17 of those late orders were the last order of the day that set a higher closing price. Mr. Ko Cho was suspended for two years.