This Week In Securities Litigation (Week ending March 10, 2017)
This week the Commission brought three actions. One, a financial fraud case, centered on one of Mexico’s largest home builder that inflated sales numbers. A second was brought against an investment adviser who failed to disclose certain conflicts arising from its relationship with a clearing broker. A third case was based on a scheme to inflate the firm’s revenues with sham transactions.
The Manhattan U.S. Attorney’s Office announced a guilty plea to securities fraud by an official of a municipal entity in connection with defrauding investors who purchased municipal securities used to construct a minor league baseball park. The guilty plea is believed to be the first to a violation of the federal securities laws tied to a municipal bond offering.
Award: The Commission announced that economist Dr. Giulio Girardi, a branch chief in the Division of Economic and Risk Analysis’ Office of Risk Assessment received The Financial Analyst Journal’s Graham and Dodd Top Award for 2016. The award was for a paper he co-authored titled “Interconnectedness in the CDS Market” with former DERA visiting scholar Mila Sherman and former SEC Chief Economist Craig Lewis. The paper assesses the stability of the credit default swap market and potential contagion among market participants.
SEC Enforcement – Filed and Settled Actions
Statistics: Last week the SEC filed 2 civil injunctive case and 1 administrative proceedings, excluding 12j and tag-along proceedings.
Financial fraud: SEC v. Notis Global, Inc., (C.D. Cal. Filed March 9, 2017) is an action which names as defendants the firm, known as Medbox, Inc.; Vincent Mehdizadeh, at one point COB and COO of Medbox; Bruce Bedrick, at one point CEO of Medbox; Yocelin Legaspi, the CEO, secretary and CFO of New-Age Investment Consulting, Inc. and the fiancée of Mr. Mehdizadeh; and New-Age, a firm formed by Mr. Mehdizadech. Medbox assists those seeking to obtain marijuana dispensary licenses in states where this is permitted. It also developed a machine called “Medbox” which dispenses marijuana on the basis of biometric identification. Medbox claimed to be a leader in its field. From 2012 through 2014 Mr. Mehdizadeh implemented a scheme to artificially boost the firm’s revenues using sham transactions. Essentially, shares of Medbox were transferred to New-Age using false documents representing that the securities were either purchased or for services received. The shares were then sold into the public market despite the fact that they were restricted, generating millions of dollars. Those funds were then transferred back to Medbox for various items such as the purchase of its receivables which were never collected. The funds from these transaction represented 22% and 65% of Medbox’s reported revenues for, respectively, 2012 and 2013. In 2014 another sham transaction was implemented between the two companies which again was used to inflate the revenue of Medbox. Press releases were issued touting the firm’s “record revenue.” Following a 2014 internal investigation Medbox restated its financial statements, reversing the New-Age transactions. Mr. Mehdizadeh was later ousted from the firm. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and each subsection of 17(a), Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 15(a) and SOX Section 304. The firm and Mr. Mehdizadeh agreed to settle the action. Mr. Mehdizadeh will pay more than $12 million in disgorgement and penalties. He also agreed to be barred from serving as an officer or director of a public company and to the entry of a penny stock bar. The litigation is continuing as to the other defendants.
Conflicts: In the Matter of Voya Financial Advisors, Inc., Adm. Proc. File No. 3-17870 (March 8, 2017) names the registered investment adviser as a Respondent (previously known as ING Financial Partners, Inc.) whose parent is listed on the NYSE. The Order is based on undisclosed conflicts arising from the relationship between the adviser and its clearing broker. Specifically, the clearing broker provided execution, custody and reporting services for the Adviser’s clients. The clearing broker also offered a certain mutual fund program to the Respondent and other advisers under which it waived fees for clients of participating advisers. Under the terms of its agreement with the Adviser, the clearing broker shared a certain percentage of revenues from the fund program. Under a separate arrangement the clearing broker also paid fees to the Adviser in return for certain administrative services furnished with respect to the funds. The Adviser disclosed its relationship with the clearing broker, the no transaction fee arrangement for the funds and the fact that this could represent an incentive to select the clearing broker’s funds. It did not disclose the fact that the payments presented an additional conflict of interest. Similarly it did not disclose the payments for the administrative services. During the period the Adviser had a policy and procedure requiring the disclosure of conflicts. The Order alleges violations of Advisers Act Sections 206(2), 206(4) and 207. In connection with resolving the matter, the firm agreed to certain undertakings regarding notice of this matter to the clients and furnishing a certificate of compliance. The Adviser consented to the entry of a cease and desist order based on the Sections cited in the Order and a censure. The firm agreed to pay disgorgement of $2,621,324, prejudgment interest and a penalty of $300,000.
SEC v Neilson, Civil Action No. 16-cv-5475 (D.N.J.) is a previously filed action against the former senior vice president of Oklahoma-based BOK Financial. The complaint alleged that the Defendant was largely responsible for the failures of the bank’s corporate trust department while overseeing what turned out to be a series of fraudulent bond offerings that are the subject of a separate enforcement action. The Court entered a financial judgment prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and ordered the payment of $29,624.03 in disgorgement (bonus compensation she received for working on the offerings), prejudgment interest and a civil penalty of $21,167.05. The bank previously settled with the Commission in a separate administrative proceeding. See Lit. Rel. No. 23772 (March 7, 2017).
Financial fraud: SEC v. Desarrolladora Homeex S.A.B. de C.V., Civil Action. No. 3:17-00432 (S.D. Cal. Filed March 3, 2017). Homex, based in Culiacan, Sinaloa, Mexico, was at one time known as Mexico’s largest home builder. The firm specialized in constructing affordable, middle-class homes in Mexico. Its ADRs were listed for trading on the NYSE from 2004 through 2014 and shares were traded in Mexico. Revenue recognition policies at the firm – the central issue here – specified that Homex recognize revenue from a home sale only if specific criteria were met. Essentially “control” of the home had to be transferred to the buyer and it had to be probable that Homex would receive the economic benefits associated with the transaction.
During the period the firm maintained an internal system called Sistema Integral de Administration or SIA where accounting entries were recorded. The firm’s CEO strictly limited employee access to the system. Beginning in 2010 manual entries for home sales and the related revenues and expenses were entered into the system. This materially inflated the financial results of the firm. For example, in 2010 the firm reported revenue of $18,465 million on the sale of 44,347 unites. In fact revenue was only $6,456 million for 16,077. Similarly, in 2011 and 2010 the firm reported inflated revenues and inflated sales numbers. The fraudulent entries were tracked on manually prepared spreadsheets. The fact that the entries were false was readily apparent from an inspection of sites were the homes supposedly were built. For example, satellite images taken in March 2012 of one project for which revenue was recorded shows that hundreds of the units had yet to be built. A photo of the satellite image is attached to the complaint and the related press release. To date the firm has not corrected, restated or made any disclosures regarding the reliability of its financial statements. There is no indication that any employees have been terminated, although the CEO and CFO did resign. No charges have been brought against the CEO, CFO or any individual. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B).
To resolve the action the company consented to the entry of an injunction based on the Sections cited in the complaint. New management cooperated with the staff. The Commission suspended trading in Homex shares.
Municipal bonds: U.S. v. St. Lawrence, Case No. 7:16-cr-00259 (S.D.N.Y.) is an action against the former Executive Director of the Ramapo Local Development Corporation for the town of Ramapo, N. Aaron Troodler. Mr. Troodler, along with Town Supervisor Christopher St. Lawrence, made material misrepresentations regarding the finances of a municipal bond offering for the construction of a minor league baseball stadium for the town of Ramapo. Mr. Troddler pleaded guilty to one count of securities fraud. This is believed to be the first conviction for federal securities fraud in connection with municipal bond issuances, according to the U.S. Attorney’s Office. Sentencing is scheduled for September 18, 2017.
Offering fraud: U.S. v. Fortenberry, Case No. 6:16-cr-00021 (N.D. Tx.) is an action in which Stanley Fortenberry was sentenced to serve 78 months in prison and pay $890,310 after pleading guilty to fraud and charges of obstructing a related SEC investigation. In one scheme Mr. Fortenberry and his firm, Premier Investment Fund, solicited funds from investors for social media projects conducted by another company with claimed ties to the country music industry. About half of the investor funds were misappropriated. In second scheme, operated in the name of his son since he was under SEC investigation, Mr. Fortenberry solicited funds for Wattenberg Energy Partners that were supposed to be used for oil and gas drilling projects. Instead of using the funds as promised, much of the money was used either in the solicitation process which was conducted using several agents or diverted to personal use. See also SEC v. Fortenberry, Civil Action No. 6:16-mc-00001 (N.D. Tex.)(resolved with an order requiring the payment of disgorgement in the amount of $146,500, prejudgment interest and a penalty of $900,000).
AML: The Securities and Futures Commission reprimanded Guangdong Securities Limited and fined the firm $3 million for failing to comply with anti-money laundering guidelines when handling third party payments. The regulator concluded that over a period of about two years beginning in February 2011 the firm’s internal controls for handling payments from client accounts to third parties were deficient. The broker failed to establish that it had conducted appropriate inquiries before processing third party payments. In addition, the firm’s records did not reflect the reasons for approving transactions.