This Week In Securities Litigation (Week of August 17, 2020)
The Fifth Circuit Court of Appeals rejected another challenge to the constitutionality of the Commission’s ALJs. The claim turned on whether those judges are unconstitutionally protected from removal. In a 2-1 decision the Court adopted the position of DOJ, representing the Commission, that the issue had to be presented first in the administrative proceeding initiated by the agency. Cochran v. SEC, No. 19-10396 (5th Cir. August 11, 2020).
The Commission filed actions last week which included: a financial fraud case tied to Hertz; an insider trading action; and the failure of a broker-dealer to file SARs.
Be safe and health this week
SEC Enforcement – Filed and Settled Actions
The Commission filed 5 civil injunctive actions and 4 administrative proceedings last week, excluding 12j and tag-along-proceedings.
Financial fraud: SEC v. Frissora, Civil Action No. 2:20-cv-10453 (D. N.J. Filed August 13, 2020) is an action which names the former CEO and Chairman of Hertz Holdings, Inc., the public holding company parent of the one-time rental car giant of the same name. Over a two year period during 2013 and 2014 as the company was failing, Defendant repeatedly urged subordinates to find ways to financially improve the results. Approximately 17 material errors resulted; revenue was overstated by about $235 million. Those errors appeared in three key areas. First, the reserve accounts were targeted. Subordinates were urged to “find money” for the company through a re-analysis of its reserves which totaled $1 billion. The result was a series of inappropriate accounting adjustments. Second, the holding period for cars was altered which inpacted the depreciation calculations of its car rental assets, lowering short-term expenses. Third, earning estimates in 2013 were reaffirmed at a time when in fact it was likely that earnings would be lower. In fact, the earnings were lower. In mid-2015 Mr. Frissora left the company. Hertz then restated its financial statements. The complaint alleges violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 15(d) and SOX section 304. The case is pending. Previously, the company and its former controller resolved fraud and related charges, paying $16 million in settlement.
Conflicts – Investment Adviser: In the Matter of SCF Investment Advisors, Inc., Adm. Proc. File No. 3-19912 (August 13, 2020) is a proceeding which names as a respondent the registered investment adviser. Beginning in early 2014 Respondent purchased, recommended or held for advisory clients, fund shares on which 12b-1 fees were received without disclosure to the clients. Second, the firm had since March 2017 recommended that clients purchase shares for which the adviser received undisclosed compensation although they were more expensive than others. By engaging in these practices Respondent breached its fiduciary duty, failed to obtain best execution and failed to properly implement an appropriate compliance system. The Order alleges violations of Advisers Act Sections 206(2) and 206(4). To resolve the proceedings Respondent agreed to implement certain undertakings it proposed, consented to the entry of a cease and desist order based on the sections cited in the Order and to a censure. The firm also agreed to pay disgorgement of $544,446.34, prejudgment interest of $22,746.63 and a penalty of $200,000. A fair fund will be created into which the funds will be placed for investors.
Crypto currency: In the Matter of Kelvin Boon, LLC, Adm. Proc. File No. 3-19913 (August 13, 2020) is a proceeding which names as Respondents the firm and is founder, Rajesh Pavithran. Over a three month period, beginning in November 2017, Respondents conducted an offering of Boon Coins, a crypto currency on a blockchain or digital ledger, raising $5 million. The coins were supposedly traded on their platform which was claimed to be more stable than others and tied to a superior blockchain. In fact, the coins, touted as having value as an investment, were unregistered securities. The claims regarding the platform, volatility and the blockchain were false. The Order alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). To resolve the matter Respondents consented to the entry of a cease and desist order based on the sections cited in the Order. Respondent Pavithran also agreed to the entry of an order prohibiting him from being an officer or director of any public company and agreed to pay a penalty of $150,000. The firm agreed to implement a series of undertakings. It will also pay disgorgement of $5 million and prejudgment interest of $600,334.50. All of the funds paid by the Respondents will be transferred to the U.S. Treasury subject to Exchange Act Section 21F(g)(3).
Churning: SEC v. Barish, Civil Action No. 1:20-cv-06437 (S.D.N.Y. Filed August 13, 2020) is an action which names as a defendant Ross Barish, a Commission registered broker who previously settled a Montana Securities and Insurance Commission claim alleging that he churned four accounts. Over a six year period, beginning in 2013, Defendant used repeated patterns of rapid trading in an out of stocks in 11 accounts which resulted in $800,000 in losses for the customers and $400,000 in commissions. He also made unsuitable recommendations and material misrepresentations to clients, all while employed at the Mineola, New York office of a broker. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 24868 (August 13, 2020).
Insider trading: SEC v. Stewart, Civil Action No. 1:15-cv-03719 (S.D.N.Y.) is a previously filed action against Sean Stewart who had worked at two different investment banks. During his employment he repeated tipped his father, Robert Stewart, in advance of acquisitions. The father and his trading partner, Richard Cunniffe, trade obtaining profits of about $1.1 million. The two traders previously pleaded guilty in a parallel criminal case. Sean Stewart was found guilty by a jury after trial. He was sentenced to serve two years in prison. In this case he consented to the entry of a permanent injunction based on Exchange Act Sections 10(b) and 14(e). The Court entered the judgment. See Lit. Rel. No. 24867 (August 13, 2020).
Unregistered broker: SEC v. Tenhulzen, Civil Action No. 8:20-cv-01890 (M.D. Fla. Filed August 13, 2020) is an action which names as a defendant Dale Tenhulzen. Defendant controlled Live Wealthy Institute, LLC., also a named defendant. Defendants were employed by EquiAlt LLC to sell securities. EquiAlt was in fact a massive Ponzi scheme that is the subject of another Commission enforcement action. Here, from 2015 to 2019, Defendants solicited 60 investors to purchase shares that were unregistered. They were paid $1.5 million in transaction based compensation. The complaint alleges violations of Securities Act Sections 5(a) and 5(c) and Exchange Act Section 15(a)(1). The case is pending. See Lit. Rel. No. 24866 (August 13, 2020).
Possible illegal conduct: In the Matter of Brian Dee Matlock, CPA, Adm. Proc. File No. 3-19914 (August 13, 2020) is a proceeding which names as a respondent the engagement partner from audit firm Rothstein, Kass & Co., P.C. on the audit of Breitling Energy Corp., Inc. During the audit of the two-year period ended December 31, 2013 Respondents became aware that Breitling’s predecessor, Breitling Oil and Gas Corporation, was misrepresenting its business model to investors who were purchasing oil and gas interests sold by the firm and inflating the returns. Respondents also became aware that certain procedures designed to safeguard investor funds were not being implemented. No action was taken. The order alleges violations of Exchange Act Section 10A(b)(1)(A)(i) and Rule 2-02(b)(1) of Regulation X. To resolve the proceedings Respondent consented to the entry of a cease and desist order based on the section and rule cited in the Order. He is also denied the privilege of appearing and practicing before the Commission as an accountant but may apply for re-instatement after one year.
Fraud-investment adviser: SEC v. Ross, Civil Action No. 2:20-cv-07202 (C.D. CA. Filed August 11, 2020). Defendant Brendan M. Ross is the founder and sole owner of Direct Lending Investments, LLC, a Commission registered investment adviser. The funds advised by Direct Lending use a master – feeder structure. A portion of the over $800 million is assets under management were loans extended by QuarterSpot, Inc., a New York based maker of small business loans. Mr. Ross focused on the return of the funds, frequently touting their strong historical performance. In 2014 performance changed. QuarterSpot began having delinquencies. Under the terms of the firm’s valuation process those delinquencies required downward deductions in the valuation of the loans. As the delinquencies continued, the terms of the firm’s valuation policy required mark downs that should have been as much as 50% to 100% in some instances. To address the delinquency question Mr. Ross began directing QuarterSpot, in early 2014, to rebate a portion of its servicing fees by making payments to the funds. Those payments were recorded to make it appear that in fact there were no delinquencies – the loans looked like they were current despite the fact that they were not. Thus, over a three-year period that continued to 2017, the funds’ value did not decline. To the contrary, during the period the value of the funds was overstated by about $53 million – returns were materially misstated. In addition, the management and performance fees were overstated by about $5 to $6 million. The reports filed with the Commission on Form ADV also reflected the falsely inflated values. The materials furnished to investors were the same – they reflected the false values. The arrangements Mr. Ross made with QuarterSpot to inflate the valuations were concealed. Following an internal investigation which uncovered the wrongful actions Mr. Ross resigned in March 2019. The complaint alleges violations of Advisers Act Sections 206(1), 206(2) and 207 as well as Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. (August 11, 2020).
Free riding: SEC v. Nguyen, Civil Action No. 2:20-c-01582 (D. Ariz. Filed August 11, 2020) is an action which names as defendants Vu Anh Nguyen along with Adam M. Reed and Anthony X. Moya. Over a period of two years, beginning in 2018, Mr. Nguyen engaged in a free riding scheme. To implement the scheme he would open a brokerage account, place trades and then take the funds in the account, leaving the trades unsettled. He was ultimately able to transfer out about $61,888. Defendants Reed and Moya assisted by opening other accounts. Overall the scheme was run through 26 accounts at 8 brokerage firms and involved transfers and purchases of about $16 million in securities. The complaint alleges violations of Exchange Act Section 10(b). Defendants Nguyen and Reed settled, each consenting to the entry of a permanent injunction based on the section cited in the complaint. Conduct based injunctions were also imposed. See Lit. Rel. No. 24864 (August 11, 2020).
AML: In the Matter of Interactive Brokers LLC, Adm. Proc. File No. 3-199-7 (August 10, 2020). Interactive Brokers is a Greenwich, Connecticut Commission registered broker-dealer whose ultimate parent is a public company. The firm acts as a retail and clearing broker. The firm does not engage in proprietary trading. The firm’s clients did engage in a number of transactions involving microcap securities. For example, Interactive Brokers accepted deposits for about 3,800 microcap securities during the period here. Yet the firm’s business in this area involved only a small number of customers. Ten customers, for example, had net sales of over 4.7 billion shares of U.S. microcap securities involving about $27.6 million. Personnel at the firm were trained to monitor for “red flags” that might indicate money laundering or terrorists financing activities as part of its AML compliance program. Nevertheless, the firm failed to investigate or file a SAR in connection with a number of suspicious transactions involving the deposit, sale and withdrawal of funds over a short period of time. Specifically, the firm failed to investigate 78 such transactions even when they represented a substantial percentage of the daily trading volume for a particular security or the shares had been subject previously to a trading suspension. These transactions involved at least $100,000 was involved. The firm also ignored other red flags. For example, a sample of 309 issuers found 58 instances where customer sales represented at least 90% of the daily trading volume. In addition, 126 instances were identified where the customer sales constitute at least 70% of the daily trading volume. Interactive Brokers took no action. Finally, in three instances during the period the broker failed to timely file a SAR where it identified red flags which included the fact that the customers had previously violated the securities or other criminal laws. While the firm did restrict the trading of those customers, no SAR was filed. The Order concluded that the firm violated Section 17(a) of the Exchange Act and Rule 17a-8 which requires broker-dealers registered with the Commission to comply with the reporting, record-keeping requirements of the Bank Secrecy Act and the related regulations promulgated by the Financial Crimes Enforcement Network or FinCEN.In resolving the action here Interactive Brokers took certain remedial steps. The firm consented to the entry of a cease and desist order based on the section and rule cited and to a censure. The firm also agreed to pay a civil penalty of $11.5 million. See also In the Matter of: Interactive Brokers LLC, CFTC Docket. 20-25 (August 10, 2020)(Interactive Brokers agreed to pay a penalty of $12 million for AML violations). The firm also agreed to pay $15 million to settle similar charges with FINRA.
Valuation: The Australian Securities and Investment Commission cautioned firms about valuations. While the regulator acknowledged that valuations of certain assets in managed funds may be difficult to determine, and the question may be more complex during the pandemic, it is still important to have proper and reasonable valuations.
Remark: Ravi Menon, Managing Director, Monetary Authority of Singapore, delivered remarks at the Singapore FinTech Festival titled Leading Through a Crisis (August 13, 2020) (here). His remarks focused on the progress made toward the vision of a Smart Financial Center.