This Week In Securities Litigation (Week of June 22, 2020)

The Commission, like all independent regulatory agencies, was created to be apolitical – a difficult task in this day and age. Despite the difficulties, it is essential that the agency continue to maintain that posture even in the face of the news events of the weekend. That is a point all should agree with regardless of views on the Battle of Manhattan that unfolded involving the U.S. Attorney’s Office and the SEC. Perhaps the only thing that is clear about that battle is that the complete story has yet to be told.

At the Commission, its experiment to gather data regarding the maker-taker practices in the markets never got off the ground. The D.C. Circuit granted a petition for review at the request of the New York Stock Exchange after concluding that the agency had no authority to write rules for such a program.

The agency did continue to file enforcement actions last week. Those actions focused on a stock manipulation, the misappropriation of brokerage client funds and a failure to make the necessary disclosures regarding certain reserves.

Be safe this week


Extension: The Commission extended the conditional relief initiated in March 2020 regarding in-person voting requirements for fund boards to December 31, 2020.

Whistleblowers: A whistleblower was awarded almost $700,000 by the agency for providing important information regarding an enforcement action that returned funds to investors, according to a June 19, 2020 announcement.

SEC Enforcement – Filed and Settled Actions

The Commission filed 3 civil injunctive actions and 1 administrative proceeding last week, excluding 12j and tag-along-proceedings.

Reserves: SEC v. Amtrust Financial Services, Inc., Civil Action No. 1:20-cv-4652 (S.D.N.Y. Filed June 17, 2020) is an action which names as defendants the firm, a specialty insurance carrier, and Ronald E. Pipoly, Jr., its CFO. The firm was required under GAAP to maintain reserves tied to its policies. GAAP also requires the disclosure of what is called Management’s Best Estimate of those reserves. Here Defendants failed to make the required disclosures over a period of about six years tracing back to March 2010. Specifically, Defendants failed to disclose the methodology for the calculations, the manner in which the reserves were calculated, and the consolidated accounting adjustments that diverged from internal actuarial estimates. The complaint alleges violations of Securities Act Section 17(a)(2) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). Defendants resolved the matter, consenting to the entry of permanent injunctions based on the sections cited in the complaint. The firm will pay a penalty of $10.3 million while Mr. Pipoly will pay disgorgement of $140,000, prejudgment interest of $22,499 and a penalty of $75,000. See Lit. Rel. No. 24838 (June 17, 2020).

Offering fraud: SEC v. Adams, Civil Action No. 24837 (C.D. Cal.) is a previously filed action which alleged that defendants Daniel Adams, a convicted felon and movie producer, Michael Flanders, a music producer, and their firms defrauded two investors in connection with their investments in the firms which were based on fabricated documents. The final judgments as to the two individual defendants enjoin each from future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The Court also entered conduct-based injunctions. In addition, Mr. Adams was ordered to pay disgorgement of $50,562, prejudgment interest of $7,087.99 and a penalty of $50,562. Mr. Flanders was directed to pay disgorgement of $28,500, prejudgment interest of $4,354 and a penalty of $28,500. See Lit. Rel. No. 24837 (June 16, 2020). The entity defendants previously settled with the Commission.

Advertising: In the Matter of Raymond J. Lucia Companies, Inc., Adm. Proc. File No. 3-15006 (June 16, 2020). This action is on remand from the Supreme Court. Raymond J. Lucia, vs. Securities and Exchange Commission, 138 S.Ct. 2044 (June 21, 2018). The proceeding, which names as Respondents the registered investment adviser and its owner, centered a marketing efforts by Mr. Lucia and Raymond J. Lucia Companies, Inc., the registered adviser, regarding their “Buckets of Money” investment program. Specifically, at various seminars investors were shown a slide presentation regarding the strategy which keyed to allocating assets to short, medium and long term buckets. Part of the strategy involved periodically reallocating assets. The approach was supposedly based on historical tests that were called “backtests,” presented as tests of the strategy over years. While the backtests were supposed to be an accurate presentation of the historical performance of the strategy, the Commission alleged that they were materially misleading. The agency alleged that the backtests did not follow the buckets of money approach and failed to disclose key issues regarding fees and other matters. The Order alleged violations of Advisers Act Sections 206(1), 206(2) and 206(4). The Commission entered an order making findings detailing the failings of the Buckets of Money presentations. The agency also concluded that there were violations of the Sections of the Advisers Act cited above. Accordingly, a cease and desist order as to Mr. Lucia and his firm, based on the statutory sections cited, was entered. Mr. Lucia was barred from the securities business with the right to apply for reentry three years from the effective date of the original Commission Opinion, September 3, 2015. Mr. Lucia was also directed to pay a penalty of $25,000.

Misappropriation: SEC v. Stow (M.D. Ten. Filed June 12, 2020) is an action against Frederick Stow, a former registered representative at a national brokerage firm. Over a three year period, beginning in late October 2015, the former broker systematically misappropriated funds from the account of a World War II vet. When the man passed away, Defendant began to plunder the account of another firm client before his malfeasance was discovered. Almost $1 million was stolen. The complaint alleges violations of Exchange Act Section 10(b). The case is pending.

Manipulation: SEC v. Gomes, Civil Action No. 1:20-cv-11092 (D. Mass. Filed June 9, 2020). Named as defendants were five Canadian citizens: Nelson Gomes, Michael Luckhoo, Shane Schmidt, Douglas Rose and Kelly Warawa. A series of entities based in Hong Kong, with one exception, were also named as Defendants. The manipulation involving Sandy Steele shares, a firm formed in Minnesota decades ago, is typical of each. Defendant Schmidt had the firm make filings in early 2019 regarding a claimed change in control to a person named John Scott — actually Defendant Schmidt. The next step was to issue millions of shares of stock. Defendant Schmidt, in conjunction with other individual defendants, had the firm issue millions of what purported to be unrestricted shares of stock. The stock was supposedly from a promissory note Sandy Steele had entered into with Arectex Capital, Inc. about three years earlier. The note was then sold in four equal segments to the original Sandy Steele shareholders. The firm’s transfer agent issued 3 million shares to each of the four shareholders under the terms of the notes based on a lawyer’s letter. The shares were not restricted. The shares eventually were moved to Mr. Schmidt who also arranged to have a block of restricted preferred shares issued to Mr. Scott – actually Mr. Schmidt. By mid-September a stock which had been trading for a few cents per share was about have a share and volume increase. Mr. Schmidt created a corporate website for the firm, IP address Vancouver, Canada. The website falsely claimed the company was manufacturing and selling garments, as reflected in the attached pictures. The stock price began to move up. By March 2020 the group employed an email marketing service to further boost the stock price. An email was sent at the behest of the group from “” noting that investors who wanted to capitalize on COVID-19 should acquire shares since they were set to increase in value by 200%. Volume in the stock spiked up in late March to over 3 million shares per day. Defendants began dumping their shares. Although the Commission eventually halted trading many of the shares had been sold. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a)(1) and (3) and Exchange Act Sections 10(b), 13(d), 15(b) and 20(e). The case is pending.

Court of Appeals

Pilot Program: The Commission adopted Rule 610T in mid-December 2018 in an effort to collect data regarding maker-taker fees, an often talked about practice. Petitioner New York Stock Exchange filed suit to halt the Pilot Program. The complaint alleged that the Commission had exceeded its statutory authority in adopting a rule all agreed imposed significant costs on at least some market participants. The Court agreed. New York Stock Exchange LLC v. Securities and Exchange Commission, No. 19-1054(D.C. Cir. Decided June 16, 2020).

The key here is the Supreme Court’s decision in Chevron v. Natural Resources Defense Council, 467 U.S. 837 (1984). Under that decision a precondition to deference is a congressional delegation of administrative authority – no delegation, no deference. In this context, ambiguity is not a delegation and not entitled to deference.

The Commission claimed that it has rule making authority under Section 23(a) of the Exchange Act. That Section in part empowered the agency “to make such rules and regulations as may be necessary or appropriate to implement the provisions . . .” of the Act. The Section also provides that the agency “shall not adopt any . . . rule or regulation which would impose a burden on competition not necessary or appropriate in furtherance of the purpose . . .” of the Act.

While there is no doubt that the SEC has rule making authority under Section 23(a), that does not mean it has delegated authority to adopt a particular regulation. At issue here is the Commission’s adoption of the Pilot Program without any regulatory agenda – there was no problem to correct with the rule. Yet it is clear that the proposed program will impose significant burdens. While the Commission claims that the program was designed to “shock” the market and develop valuable information, it is beyond dispute that the agency has never adopted such a rule. The Commission claim that the rule is reasonably related to the Act is not sufficient. There is simply nothing in the Exchange Act that permits the SEC to adopt what it admits is a “one off” program.

“Normally, unless an agency’s authorizing statute says otherwise, an agency regulation must be designed to address identified problems” the Court stated. This is because “Rules are not adopted in search of regulatory problems to solve; they are adopted to correct problems with existing regulatory requirements that an agency has delegated authority to address.” This is not the case here.

Finally, the Commission’s claim that it had implied authority to adopt Rule 610T misses the mark. The argument is based on a confused interpretation of cases involving the question of implementing an experimental initiative. That is not what happened here. To the contrary, the “problem in this case is that the Commission acted in excess of its authority under the Exchange Act. It adopted the Pilot Program without any regulatory agenda . . . without explaining what problems with the existing regulatory requirements it meant to address . . . [and] significant, costly, and disparate regulatory requirements on only a subset of the securities market just to gather data.” This, the Court concluded is not permissible. The Petition for Review was granted.

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