This Week In Securities Litigation (Week ending May 20, 2016)

The Supreme Court concluded this week that a suit based on short selling filed in state court alleging state law causes of action was not preempted by the exclusive jurisdiction provision of Exchange Act Section 27 simply because it cited an SEC regulation precluding naked short selling. In reaching its conclusion the High Court concluded that the test is whether the claims “arise under” the Exchange Act.

The SEC, along with the Manhattan U.S. Attorney’s Office, brought an insider trading action claiming a Dean Food board member repeatedly tipped a Las Vegas professional sports gambler who traded, making millions of dollars in profits. Golfer Phil Mickelson, who traded on information from the tippee, was names as a relief defendant. The Commission and FINRA also filed actions centered on municipal bond offerings this week.


Whistleblowers: The agency announced a $5 million whistleblower award, the third highest in the history of the program.

Proposed rules: The SEC, in conjunction with the FDIC, FHFA, Federal Reserve, NCUA and Office of the Controller invited comment on a proposed rule to prohibit incentive based pay that encourages inappropriate risk-taking in financial institutions (here).


Remarks: Jamal El-Hindi, Deputy Director, delivered remarks at the Institute of International Bankers Annual Anti-Money Laundering Seminar (May 16, 2016). His remarks focused on the recent Customer Due Diligence Rule (here).

Supreme Court

Jurisdiction: Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, No. 14-1132 (S.Ct. Decided May 16, 2016). The case centers on the interpretation of the exclusive jurisdiction provision of Exchange Act Section 27. Its factual claims concern naked short selling. Respondent Greg Manning held over two million shares of Escala Group, Inc., traded on NASDAQ. Between 2006 and 2007 the share price plummeted. The investment lost most of its value. Mr. Manning claimed that the share price dropped because of naked short selling by Merrill Lynch and other financial institutions. In his complaint, Mr. Manning and several other Escala shareholders alleged that Merrill Lynch facilitated and engaged in naked short sales of the stock in violation of New Jersey law. Merrill Lynch removed the complaint to federal district court. That court denied Mr. Manning’s request for remand. The third circuit reversed. The Supreme Court affirmed.

Justice Kagan, writing for six members of the Court, began with the text of Section 27 which clearly gives federal district court’s exclusive jurisdiction of claims brought under the Exchange Act. The text, the Court concluded, supports the interpretation that the exclusive jurisdiction applies to suits “arising under” the Exchange Act, a phrase found in the general federal question statute, 28 U.S. C. § 1331. Indeed, the Court’s “precedents interpreting identical statutory language positively compel that conclusion.”

There is no doubt that, as Mr. Manning contends, a complaint which asserts a right of action deriving from the Exchange Act, or one of its regulations, must proceed in federal court. Likewise, as Merrill Lynch contends, if a state-law action necessarily “depends on a showing that the defendant breached the Exchange Act, then that suit could also fall within § 27. The existing jurisdictional test of “arising under” captures both of these prospects: “This Court has found that statutory term satisfied in either of two circumstances. Most directly, and most often, federal jurisdiction attaches when the federal law creates the cause of action asserted . . . [and] As this Court has explained, a federal court has jurisdiction of a state-law claim if it necessarily raises a stated federal issue, actually disputed and substantial, which a federal forum may entertain without disturbing any congressionally approved balance of federal and state power.” (internal quotations and citations omitted). This is the situation here.

The Court has reached the same conclusion before. In Pan American Petroleum Corp. v. Superior Court of Del. for New Castle City, 366 U.S. 656 (1961) when construing § 22 of the Natural Gas Act – an exclusive jurisdiction Section with the same language as here – the Court concluded that the phrase “brought to enforce” should be construed using the “arising under” test. Similarly, in Matsushita Elec. Industrial Co. v. Epstein, 516 U.S 367 (1996) which “addressed § 27 itself . . . [the Court] once again equated the ‘brought to enforce’ and ‘arising under’ standards.”

Finally, construing §27 in accord with its text and prior precedent “gives due deference to the important role of state courts in our federal system. . . Out of respect for state courts, this Court has time and again declined to construe federal jurisdictional statutes more expansively than their language, most fairly read, requires.

Justice Thomas filed a concurring opinion joined by Justice Sotomayor.

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 4 civil injunctive actions and 1 administrative proceedings, excluding 12j and tag-along proceedings.

Insider trading: SEC v. Walters, Civil Action No. 1:16-cv-03722 (S.D.N.Y. Filed May 19, 2016) names as defendants William T. Walters and Thomas C. Davis. Mr. Walters is the Chairman and CEO of The Walters Group. He is a professional sports bettor. Mr. Davis was a director of Dean Foods Company and a member of the audit committee. He was also a member of a group of Darden shareholders trying to institute change at the company. From 2008 through 2012 Mr. Davis repeatedly tipped his friend William Walters in advance of certain corporate events related to Dean Foods. Specifically, he tipped him in advance of six quarterly earnings announcements and the spin-off of a profitable subsidiary, The WhiteWave Foods Company. He also provided Mr. Davis in 2013 with information he obtained on a confidential basis from a group of investors seeking to institute corporate change at Darden Restaurants, Inc. Mr. Walters made at least $40 million on the trades. In exchange for the inside information Mr. Walters aided Mr. Davis with his financial difficulties by furnishing him with almost $1 million. Mr. Walters also tipped golfer Philip Mickelson in July 2012 about the Dean Foods spin-off. At the time Mr. Mickelson owed Mr. Walters money from gambling. Mr. Mickelson traded, reaping profits of about $931,000. Mr. Mickelson is named as a relief defendant. The other relief defendants are the Walters Group, a partnership of Mr. Walters and his wife whose account he used to trade on inside information; and Nature Development B.V, a company which is indirectly controlled by Mr. Walters whose brokerage account was used to trade on inside information. The complaint alleges violations of Exchange Act Section 10(b). The complaint claims that each of the relief defendants had gains over which they have no legitimate claim. Accordingly, disgorgement is sought. The U.S. Attorney’s Office for the Southern District of New York filed parallel criminal charges against Mr. Walters. Mr. Davis has pleaded guilty to conspiracy, securities fraud, wire fraud, obstruction of justice and perjury. He is cooperating with the government. Both cases are pending.

Muni bonds: SEC v. Kellogg, Civil Action No. 16-cv-5384 (S.D. Ill. Filed May 19, 2016) is an action which names as a defendant Eric Kellogg, then the Mayor of the City of Harvey, Illinois. The action centers on three municipal bond offerings between 2008 and 2010. Each offering was to raise funds to develop and construct a Holiday Inn Hotel in Harvey. The bonds were to be repaid from dedicated tax revenue of incremental tax from the Tax Incremental District within the Hotel Redevelopment Project. In fact Harvey officials improperly diverted at least $1.7 million of bond proceeds to the general operation accounts of Harvey to pay the City’s operation costs. The town’s former controller also got about $290,000 of the proceeds. Previously, the City and former Controller were named in a Commission complaint alleging violations of Exchange Act Section 10(b). Each defendant settled, consenting to the entry of permanent injunctions based on the Section cited in the complaint. The complaint against Mr. Kellogg alleged violations of Exchange Act Section 20(a). To resolve the case Mr. Kellogg consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b). The order also prohibits him from participating in an offering of municipal securities including engaging in activities with a broker or issuer for purposes of issuing or trading any such security. Mr. Kellogg will pay a $10,000 penalty. See Lit. Rel. No. 23543 (May 19, 2016).

Offering fraud: In the Matter of James A. Winkelmann, Adm. Proc. File No. 3-17253 (May 19, 2016) is a proceeding with names as Respondents Blue Ocean Portfolios, LLC, a registered investment adviser, and Mr. Winkelmann, the indirect owner of the adviser and its Principal/CEO, COO and Manager. The action centers on the sale of Blue Ocean securities largely to advisory clients. In the course of those offerings Respondents raised about $1.4 million from 24 investors using a series of misrepresentations which oversated the advisers success, misstated the alignment of Mr. Winkelmann’s interest and those of the adviser, and made misleading statements about an associate of Mr. Winkelmann who was a radio show host touting the stock. The Order alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2), 206(4) and 207. The matter will be set for hearing.

Fraudulent fees: SEC v. McLellan, Civil Action No. 1:16-cv-10874 (D. Mass. Filed May 13, 2016). Defendant Ross McLellan was the Senior Managing Director and Global Head of State Street Corporation’s Transition Management line of business. He was registered with the broker-dealer affiliated with State Street Global Markets LLC.

From early 2010, through the fall of 2011, State Street offered Transition Services to customers in the U.S. and elsewhere. State Street claimed to offer a unique Transition Model that was conflict free and in which it acted as a fiduciary following best practices principles. In 2010 State Street began to experience a shortage of major Transition Management deals. That impacted the financial performance of the Portfolio Solutions business. From February 2010 through September 2011 Mr. McLellan, along with Employees A and B, charged hidden mark-ups to Transition Management customers to generate additional revenue. Mr. McLellan also gave specific instructions to keep the additional charges hidden. During the period additional charges were added to the transition for a Middle Eastern Sovereign Wealth Fund, an Irish Government Agency and a British Postal Company. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 23540 (May 13, 2016). The U.S. Attorney’s Office for the District of Massachusetts filed a parallel criminal action against Mr. McLelland and another individual. The UK’s Financial Conduct Authority found that State Street deliberately overcharged six customers $20,169,602 and imposed a financial penalty of £22,885,000.

Offering fraud: SEC v. Rust, Civil Action No. 1:16-cv-03573 (S.D.N.Y. Filed May 13, 2016). Defendants Jay Rust and Christopher Brenner are attorneys licensed to practice law in the State of Texas. Atlantic Rim Funding is the alter ego of Individual X, a person currently serving a 20 year term in a California prison for securities fraud unrelated to this action. Attorney Rust was recruited by Individual X, a person he knew, in November 2011to serve as an escrow agent for a commercial lending program with Atlantic. The program called for would-be borrowers to deposit cash amounting to ten percent of an anticipated loan. Those funds would then be leveraged to secure a loan ten times the amount of the deposit, according to the sale pitch. Mr. Rust, secretly paid by Individual X, assured investors that he would serve as the escrow agent on their behalf, protecting their deposits, the securities purchased with their cash and the loan proceeds. Beginning in December 2010, and continuing for over the next year and one half, Mr. Rust solicited thirteen small business owners. They deposited about $8.5 million with Attorney Rust as their escrow agent. Rather than use the funds as represented Mr. Rust opened a brokerage account and traded in a manner that was not in accord with the representations made to investors. Later he misappropriated portions of the funds. Eventually new investor funds were used to repay earlier investors. In early August 2011 Individual X replaced Attorney Rust with Attorney Brenner who, like Attorney Rust, was familiar not just with him but also his schemes. He repeated the same scheme that Attorney Rust had executed. From September 2011 through March 2012 he secured 15 new clients for the scheme who put up $3.4 million. The results for those clients were the same as for those recruited by Mr. Rust – the funds were not invested as represented, portions were misappropriated and eventually new investor funds repaid prior investors. The complaint alleges violations of Exchange Act Section 10(b). The case is pending.


Municipal bonds: The regulator brought an action against Lawson Financial Corporation, Inc. and its President and CEO, Robert Lawson, in connection with the sale of municipal revenue bonds. The complaint centers on a $10.5 million bond offering in October 2014 for bonds relating to an Arizona charter school the firm underwrote and sold and subsequent sales in the secondary market. The complaint alleges that Mr. Lawson and the firm were aware of financial difficulties faced by the municipal revenue bond conduct borrowers and fraudulently concealed them from bond purchasers. The complaint claims that Mr. Lawson and the firm transferred millions of dollars from a deceased customer’s charitable trust to parties associated with the conduit borrowers to conceal the financial condition of the bond borrowers and the risks. The matter will be set for hearing.

AML: The regulator fined Raymond James $17 million for systematic anti-money laundering failures. The AML compliance officer, Linda Busby, was fined $25,000 and suspended for three months. Over an eight year period beginning in 2006 the firm grew rapidly but its compliance systems did not. The failure to expand the firm’s AML systems in a manner that was consistent with firm growth meant that certain “red flags” of potentially suspicious activity went undetected. Even when detected, those incidents were at times inadequately investigated. During the investigation the regulator also found that the firm failed to conduct the required due diligence and periodic risk reviews for foreign financial institutions. In addition, Raymond James failed to establish and maintain an adequate customer identification program. Ms. Busby failed to ensure that Raymond James’ reviews were conducted. This is not the first time the firm has been sanctioned for AML failures. In 2012 Raymond James was fined for having inadequate AML procedures. The resolution of that matter called for the firm to certify that it had adopted reasonably designed systems and procedures to achieve compliance.


Disclosuse: Benjamin Krkpatrick, CEO of Waratah Resources Ltd. pleaded guilty to charges brought by the Australia Securities Investment Commission of aiding and abetting the breach by his firm of its continuous disclosure obligation. Specifically, the firm disclosed in October 2013 that it had entered into a $100 million trade finance facility with the Bank of China. If fact, the statement was not true. Mr. Kirkpatrick failed to withdraw the statement over the period following its announcement as required by his continuous disclosure obligations.


Insider trading: The Financial Conduct Authority sanctioned Mark Taylor, a registered representative at Towry Limited, for purchasing shares of Ashcourt Rowan based on inside information. During negotiations by Towry to acquire Ashcourt Rowan in early 2015 an internal email referencing the then under negotiation deal was inadvertently circulated among the staff. It was then recalled in a second email which instructed the staff not to trade. Mr. Taylor read both emails and purchase 5,582 shares of Ashcourt Rowan for a total of £15,011.02. After the public announcement of the deal he sold the shares for £18,509.91, yielding a profit of £3,498. The next day he tried to recall the trade but the broker reported it to the FCA. The regulator fined Mr. Taylor £36,285 and banned him from the business for two years. A penalty of £78,819 would have been imposed but for his financial condition.

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