This Week In Securities Litigation (Week ending June 22, 2018)

Decisions by the Supreme Court were key this week. The High Court concluded that SEC ALJs were appointed in violation of the Constitution. In reaching that conclusion the Court sidestepped a second constitutional question as well as the issue of whether the earlier efforts of the SEC to cure its incorrect appointment process were adequate, leaving the remedy issue open for all but the Petitioner in the case. The Court also agreed to hear a question regarding the Commission’s long standing efforts to blur the line between primary and secondary liability next term. That case has the potential to impact not just Commission actions but also securities class actions.

The DOJ brought criminal charges against the founder and COO of once high flying Theranos. Each executive was charged with conspiracy and multiple counts of wire fraud.

The Commission filed its second action in which admissions were required. The case centered on a years long deception by brokerage giant Merrill Lynch. The agency also brought an action based on an offering fraud executed by former market professionals and another case involving a a microcap market manipulation.


Testimony: Chairman Jay Clayton testified before the House Committee on Financial Services (June 21, 2018). His testimony detailed the work of the Commission and the various staff Divisions, beginning with the new draft Strategic Plan (below) and reviewed issues regarding improving disclosure and the capital raising process, cybersecurity, ICO’s, the consolidated audit trail and the remaining Dodd-Frank rules to be written (here).

Strategic Plan: The Commission issued a draft Strategic Plan for fiscal years 2018 – 2022, inviting comment (here). The draft discusses the Commission’s mission, vision, values and goals.

Remarks: Chairman Jay Clayton delivered remarks titled Observations on Culture at Financial Institutions and the SEC, New York, New York (June 18, 2018)(here). His remarks began by focusing on a paper from the U.K.’s Financial Conduct Authority regarding culture, noted the importance of culture in the context of compliance and concluded with a review of the obligations of professionals who work in the financial services industry.

Supreme Court

Lucia v. SEC, No. 17-130 (Decided June 21, 2018) resolved the question of whether SEC ALJs had to be appointed in accord with the dictates of the Constitution’s Appointments Clause – that is, are they Inferior Officers of the United States? The Court, in a 7-2 decision written by Justice Kagan, held that they are — the Clause applies and the ALJs should have been appointed in accord with its dictates rather than hired by the staff.

The Court’s decision is based largely on Freytag v. Commissioner, 501 U.S. 868 (1991) which “says everything necessary to decide this case,” according to the Court. There the Court concluded that certain tax court judges were Officers to which the Clause applied. SEC ALJs have similar duties and obligations to the judges at the tax court. Specifically, their positions have been established by law and they exercise significant discretion in creating the record for and presiding over administrative proceedings as in Freytag.

Since the ALJ who presided over Petitioner’s hearing was not appointed in accord with the Clause, a new proceeding must be brought and presided over by either the Commission or a different ALJ who has been appointed in accord with the dictates of the Clause. In reaching this conclusion the Court side-stepped the question of whether the Commission’s November 2017 order ratifying the appointment of its ALJs was adequate.

Justice Breyer dissented in part in an opinion joined by Justices Ginsburg and Sotomayor. In his opinion the Justice argued that a necessary predicate to the Appointments Clause question is one that the Solicitor General raised but the which the Court declined to consider. It centers on the application of the Administrative Procedure Act which provides for the retention of ALJs by the agency but not for the delegation of that authority to the staff. Consideration of this point could permit the Court to avoid the constitutional issue under the Appointments Clause. In addition, Free Enterprise Fund v. Public Company Accounting Oversight Bd., 561 U.S. 477 (2010) held that certain employment protections given to PCAOB board members violated the Constitution’s Vesting Clause. If that holding applied here to SEC ALJs — the Free Enterprise Court distinguished PCAOB Board members from ALJs – it would make the ALJ’s subject directly to the political processes by stripping them of their APA employment protections. This would threaten to “change the nature of our merit-based civil service as it has existed from the time of President Charles Alan Arthur,” the Justice cautioned in an argument that echoes his dissent in Free Enterprise Fund.

Lorenzo v. SEC, No. 17-1077 (certiorari granted June 18, 2018). The Supreme Court agreed to hear this case and determine a key question regarding the distinction between primary and secondary liability. Specifically, the question for resolution, according to petitioner, is as follows: “In Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), this Court considered the elements of a fraudulent statement claim and held that only the ‘maker” of a fraudulent statement may be held liable for that misstatement under Section 10(b). . .The question presented is whether a misstatement claim that does not meet the elements set forth in Janus can be repackaged and pursued as a fraudulent scheme claim.” The resolution of this question has significant implications for SEC enforcement as well as private securities class actions.

SEC Enforcement – Filed and Settled Actions

Statistics: Last week the SEC filed 4 civil injunctive cases and 1 administrative proceeding, excluding 12j and tag-along proceedings.

Offering fraud: SEC v. Hocker, Civil Action No. 4:18-cv-01251 (M.D.Pa. Filed June 21, 2018) is an action which named as a defendant insurance agent James Hocker. Over a seven year period beginning in 2010 Mr. Hocker targeted his former insurance clients and inexperienced investors, inducing them to invest with him in ventures promised to pay returns ranging from 10% to 30%. About 25 investors entrusted Mr. Hocker with a total of $1.27 million. Rather than invest the funds, Mr. Hocker misappropriated them, according to the complaint. That complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 24173 (June 21, 2018).

Deception: In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Adm. Proc. File No. 3-18549 (June 19, 2018). Over a five year period which ended in 2013 Merrill Lynch engaged in a practice known internally at the firm as “masking.” The practice involved deceiving customers – primarily financial institutions such as asset managers, mutual fund investment advisers and pension funds – about the manner in which their trades were executed. Specifically, the brokerage firm often routed customer orders to other broker-dealers, proprietary traders and market makers for execution. The practice was called Electronic Liquidity Partners or ELP. Not only did Merrill Lynch fail to tell customers about the practice, the firm deceived the traders about the manner in which their transactions were executed to the point of altering customer documents. The practice was used even where the broker received express instructions not to execute the transactions using an ELP. Despite the fact that the information about the venue and execution was important to the traders, the firm deceived them. During the five year period of the scheme over 5.4 billion shares were traded in this manner with a notional value of $141 billion. Throughout the period Merrill Lynch knew internally where the transactions were executed. Those records were maintained internally and available for regulators. In 2013 the firm elected to halt the practice but did not inform its customers. The Order alleges violations of Securities Act Sections 17(a)(2) and (3). To resolve the proceeding Merrill Lynch admitted to the facts alleged in the Order and that its conduct violated the federal securities laws. The firm consented to the entry of a cease and desist order and a censure. It also agreed to pay a penalty of $42 million.

Investment fraud: SEC v. Santillo, Civil Action No. 18-cv-5491 (S.D.N.Y. Filed June 19, 2018) is an action which names as defendants five individuals who are or were members of FINRA, although two have been either suspended or barred from association: Perry Santillo; Christopher Parris; Paul Larocco; John Picarreto; and Thomas Brenner. Also named as defendants are three entities: First National Solution, LLC; Percipience Global Corporation; and United RL Capital Services. Defendants Santillo and Parris purchase books of business from investment professionals. Once the acquisition was completed the two men, with the assistance of the other defendants, induced the clients to withdraw from their existing investments and put their investment dollars into one of the entity defendants. Thus, for example, investors who were clients of an acquired business would be induced to invest in First Nationale, a firm that purports to conduct business in areas that include leveraged investments, the financial services industry and others. In other instances investors would be induced to withdraw from existing investments and place their money in Percipience, supposedly a firm that provides loans to buy and improve homes. In other instances investors would be solicited to invest in United RL, a firm supposedly in the business of financing physician-owned toxicology laboratories. In each instance investors were solicited using misrepresentations regarding the nature of the business, the use of their funds and other matters. Investors were furnished with false statements about their investments. Investors were not told that in fact the three firms had virtually no business, that large portions of the solicited funds were being recycled to pay other investors and that the individual defendants were misappropriating large portions of the money. Of the $102 million raised by defendants at least $38.5 million was paid out to earlier investors and $20 million was transferred to personal bank accounts of individual defendants. A large portion of the remaining funds were transferred elsewhere in transactions that are not recorded on the books. The complaint alleges violations of Securities Act section 17(a), Exchange Act section 10(b) and Advisers Act sections 206(1) and 206(2). The case is pending. See Lit. Rel. No. 24172 (June 20, 2018).

Offering fraud: SEC v. Texas Coastal Energy Company, LLC, Civil Action No. 3:18 –cv-01587 (N.D. Tx. Filed June 19, 2018) is an action which names the firm and its control person, Jeffery Gordon, as defendants. Beginning in early 2013 and continuing through late 2014, Defendants raised over $8 million from about 80 investors. Those investors, solicited through cold calls in which Mr. Gordon participated, and with offering materials he prepared, were induced to invest in an oil enterprise in which they were promised a share of the revenues. In the cold calls and offering materials the experience of the firm, its reserves and the prospects of a return were misrepresented. Defendants misappropriated a significant portion of the investor funds. The complaint alleges violations of Securities Act sections 5(a), 5(c) and 17(a) and Exchange Act sections 10(b) and 15(a). To resolve the action Defendants consented to the entry of permanent injunctions based on the sections cited in the complaint as well as to a conduct injunction prohibiting them from engaging in certain transactions regarding the purchase and sale of a security. They also agreed to pay disgorgement, prejudgment interest and civil penalties totaling $7.2 million. Mr. Gordon has offered to consent to the entry of a penny stock bar. See Lit. Rel. No. 24169 (June 19, 2018).

Market manipulation: SEC v. Dynkowski, Civil Action No. 1:09 – 361 (D. Del.) is a previously filed action in which the court entered a final judgment by consent as to Defendant Richard Bailey, a former officer of GH3 International, Inc. based on his role in a pump-and-dump manipulation. The manipulation generated over $700,000 in profits. The Court’s order imposed a permanent injunction prohibiting future violations of Exchange Act section 10(b) as well as Securities Act sections 5(a), 5(c) and 17(a). The order also barred Mr. Bailey from serving as an officer or director and from participating in a penny stock offering. Financial issues are reserved for subsequent determination. This concluded the Commission’s action. See Lit. Rel. No. 24167 (June 18, 2018).

Market manipulation: SEC v. Fiore, Civil Action No. 7:18-cv-05474 (S.D.N.Y. Filed June 18, 2018) centers on the manipulation of a penny stock which netted the promoter over $11 million. Defendant Joseph Fiore controls Berkshire Capital Management Company, Inc., a private equity firm, and Eat At Joe’s, Ltd., a/k/a SPYR, Inc., an issuer that files periodic reports with the Commission. Both firms are defendants. The scheme traces to a meeting in early 2011 involving Mr. Fiore and the CEO of publically traded Plandai Biotechnology, Inc., a firm based in London, England. The firm was supposedly in the business of producing botanical extracts from live plants, including marijuana. The meeting focused on promoting the shares of Plandai. The next year Mr. Fiore acquired beneficially 5.5 million shares of Plandai, supposedly as part of a merger transaction involving and another firm. By March 2013 an agreement had been struck pursuant to which Mr. Fiore would organize the promotion of Plandai. Mr. Fiore launched the campaign, which he funded and implemented, the next month. Over the next year a series of steps were taken to manipulate the share price of Plandai, including: 1) retaining two firms to promote the stock, urging investors to buy shares in alerts, research reports and emails; 2) purchasing stock to support the price; 3) engaging in wash and matched trades to create the appearance of market activity; 4) marking the close to push up the price at the end of the trading day; and 5) painting the tape by initiating multiple orders at about the same time to move the price. During the manipulation Mr. Fiore sold about 11.9 million shares of Plandai stock for proceeds of over $11 million. The complaint alleges violations of Securities Act section 17(a), Exchange Act sections 9(a)(1), 9(a)(2), 10(b), 13(d) and 20(a) and Investment Company Act Section 7(a). The case is pending. See Lit. Rel. No. 24171 (June 20, 2018).

Misappropriation: SEC v. Fossum, Civil Action No. 2:17-cv-01834 (W.D. Wash.) is a previously filed action against Ronald Fossum. The complaint alleged that Mr. Fossum misappropriated millions of dollars in investor funds raised through three unregistered offerings. The Court entered a final judgment by consent, permanently enjoining Mr. Fossum from future violations of Securities Act sections 5(a), 5(c) and 17(a) and Exchange Act sections 10(b), 15(a) and Advisers Act sections 206(1) and 206(2). The judgment also directs that Mr. Fossum pay disgorgement of $804,729, prejudgment interest of $110,923 and a penalty in the amount of $320,000. A conduct based provision of the injunction precludes Mr. Fossum from participating in the issuance, offer or sale of any security except for his own account. Mr. Fossum has also consented to the entry of an order barring him from the securities business and from participating in any penny stock offering in a related administrative proceeding. See Lit. Rel. No. 24166 (June 15, 2018).


Attempted manipulation: In the Matter of JPMorgan Chase Bank, N.A., CFTC Docket No. 18-15 (June 18, 2018) is an action against the bank for attempted market manipulation. Specifically over a five year period beginning in January 2007 Respondent attempted to manipulate the U.S. Dollar International Swaps and Derivatives Association Fix which is set each day at 11:00 a.m. Just prior to the fix the bank repeatedly took steps to try and push the price, a point recorded in emails. In some instances the bank also tried to push the price at the daily close. These facts were openly discussed. The Order alleges violations of sections 6(c)(1), 6(c)(1)(A), 6(c)(3), 6(d) and 9(a)(2) of the CEA. In resolving the action the bank took certain remedial steps and cooperated. To resolve the proceeding the bank consented to the entry of a cease and desist order based on the sections cited in the Order and agreed to pay a $65 million penalty.

Criminal Cases

Advanced fee scheme: U.S. v. Elrod, No. 1:15-cr-00001 (D. CO); U.S. v. Dawn, No. 1:15-00040 (D. CO). On June 19 and 20, 2018 defendants Brian Elrod and William Dawn were sentenced for their role in an advanced fee scheme. Defendant Elrod was the CEO of Compass Financial Solutions while Mr. Dawn was the general counsel. Each man pleaded guilty to one count of conspiracy to commit mail fraud and wire fraud. The pleas were based on a scheme that took place from 2005 to 2011. Promissory notes were marketed to investors who were supposed to obtain a high rate of return through monthly interest payments in return for an up -front fee. In fact the funds were misappropriated. There were about $2.5 million in investor losses. Mr. Elrod was sentenced to serve 38 months in prison followed by three years of supervised release. He was also ordered to pay restitution of $2,440,051.29. Mr. Elrod, 80, who assisted with the scheme, was sentenced to time served and ordered to pay restitution of $366,752.01.

Fraud: U.S. v. Holmes, No. 5:18-cr-00258 (N.D. CA. Unsealed June 15, 2018). The founder of Theranos, Inc., Elizabeth Holmes, and the firm’s COO, Ramesh Balwani, were each indicted on charges of conspiracy to commit wire fraud and nine counts of wire fraud. The charges are tied to two schemes, one to defraud consumers and physicians and a second investors, that took place between 2006 and 2016. Specifically, defendants repeatedly claimed that they had created a revolutionary blood testing machine when raising over $700 million of financing for the company. In fact the representations were false. See SEC v. Holmes, Civil Action No. 5:18-cv-01602 (N.D. Calif. Filed March 14, 2018); SEC v. Balwani, Civil Action No. 5:18-cv-01603 (N.D. Calif. Filed March 14, 2018).

Insider trading: U.S. v. Chang, No. L18-cr-00034 (N.D.CA.) is an action in which Peter Change, the founder and former CEO of Alliance Fiber Optics Products, Inc., a manufacturer of fiber optic components, previously pleaded guilty to insider trading and tender offer fraud. Specifically, Mr. Chang admitted that he sold AFO shares shortly prior to the earnings announcements for October 28, 2015 and February 18, 2016, permitting him to avoid losses. He also traded prior to the public announcement that the firm would be acquired in April 2016. The Court sentenced Mr. Change to serve 24 months in prison. He will be subject to three years of supervised release following the completion of the prison term. See also SEC v. Chang, Civil Action NO. 5:17-cv-05438 (N.D. CA.).


Violating suspension: A hearing panel imposed a permanent bar on broker Bruce Martin Zipper, formerly a principal at his firm, Dakota Securities, and expelled the firm. The orders were entered in view of the fact that Mr. Zipper violated the three month suspension imposed on him as part of an earlier settlement. The order as to the firm was for failure to supervise.

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