Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

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Thursday, February 24, 2011

SEC Alleges International Microcap Fraud

The SEC today charged two securities professionals, a hedge fund trader, and two firms involved in a scheme that manipulated several U.S. microcap stocks and generated more than $63 million in illicit proceeds through stock sales, commissions and sales credits.  According to the SEC, Florian Homm of Spain and Todd M. Ficeto of Malibu, Calif., conducted the scheme through their Beverly Hills, Calif.-based broker-dealer Hunter World Markets Inc. (HWM) with the assistance of Homm’s close associate Colin Heatherington, a trader who lives in Canada. They brought microcap companies public through reverse mergers and manipulated upwards the stock prices of these thinly-traded stocks before selling their shares at inflated prices to eight offshore hedge funds controlled by Homm. Their manipulation of the stock prices allowed Homm to materially overstate by at least $440 million the hedge funds’ performance and net asset values (NAVs) in a fraudulent practice known as “portfolio pumping.”

The SEC additionally brought administrative proceedings against HWM’s trader and chief compliance officer, who each agreed to settle the SEC’s charges against them.

According to the SEC’s complaint filed in the U.S. District Court for the Central District of California, Homm along with Ficeto and Heatherington conducted the scheme from September 2005 to September 2007. The SEC’s complaint charges Ficeto, Homm, Heatherington, HWM, and Hunter Advisors LLC with violating the antifraud provisions of the federal securities laws, and additionally charges HWM and Ficeto with violations of several broker-dealer recordkeeping provisions. The SEC seeks permanent injunctive relief, disgorgement of illicit profits with prejudgment interest, and financial penalties. The SEC also seeks an order permanently barring Ficeto from participating in any penny stock offering or from serving as an officer or director of a public company.

The SEC instituted separate but related administrative proceedings against Ahn and HWM’s former chief compliance officer Elizabeth Pagliarini, who each agreed to settle their cases without admitting or denying the SEC’s findings. Ahn agreed to pay a $40,000 penalty, comply with certain undertakings, and be barred from association with a broker and dealer for five years. Pagliarini agreed to a $20,000 penalty and one-year suspension as a supervisor with a broker or dealer.

February 24, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Will Consider Dodd-Frank Rules at March 2 Open Meeting

The SEC will hold an Open Meeting on March 2, 2011.  The subject matter will be:

Item 1: The Commission will consider whether to propose regulations with respect to incentive-based compensation practices at certain financial institutions in accordance with Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Item 2: The Commission will consider whether to propose rules for the operation and governance of clearing agencies in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and Section 17A of the Securities Exchange Act of 1934.

Item 3: The Commission will consider whether to reopen the comment period for Regulation MC, which was proposed pursuant to Section 765 of the Dodd-Frank Act to mitigate conflicts of interest at security-based swap clearing agencies, security-based swap execution facilities, and national security exchanges that post or make available for trading security-based swaps, in order to solicit further comment on Regulation MC and other more recent proposed rulemakings that concern conflicts of interest at security-based swap clearing agencies and security-based swap execution facilities.

Item 4: The Commission will consider whether to propose a new rule and rule and form amendments under the Securities Act of 1933 and the Investment Company Act of 1940, relating to references to credit ratings. These amendments are in accordance with Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

February 24, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Charges Former TBW Treasurer with Securities and TARP Fraud

The SEC today charged Desiree E. Brown, the former treasurer of Taylor, Bean & Whitaker Mortgage Corp. (TBW), the one-time largest non-depository mortgage lender in the country, with aiding and abetting a $1.5 billion securities fraud scheme and an attempt to scam the U.S. Treasury's Troubled Asset Relief Program (TARP).

The SEC alleges that Brown helped in selling more than $1.5 billion in fictitious and impaired mortgage loans and securities from TBW to Colonial Bank and caused them to be falsely reported to the investing public as high-quality, liquid assets. Brown also helped Colonial Bank to misrepresent that it had satisfied a prerequisite necessary to qualify for TARP funds.  In a related action today, Brown pleaded guilty to criminal charges filed by the Department of Justice in the Eastern District of Virginia.

The SEC previously charged former TBW chairman and majority owner Lee B. Farkas in June 2010. Farkas also was arrested in June by criminal authorities.

 According to the SEC's complaint filed in U.S. District Court for the Eastern District of Virginia, Brown and Farkas perpetrated the fraudulent scheme from March 2002 to August 2009, when Colonial Bank was seized by regulators and Colonial BancGroup and TBW both filed for bankruptcy. TBW was the largest customer of Colonial Bank's Mortgage Warehouse Lending Division (MWLD). Because TBW generally did not have sufficient capital to internally fund the mortgage loans it originated, it relied on financing arrangements primarily through Colonial Bank's MWLD to fund such mortgage loans.

The SEC alleges that when TBW began to experience liquidity problems and overdrew its then-limited warehouse line of credit with Colonial Bank by approximately $15 million each day, Brown and Farkas and an officer of Colonial Bank concealed the overdraws through a pattern of "kiting" in which certain debits were not entered until after credits due for the following day were entered. In order to conceal this initial fraudulent conduct, Brown, Farkas and the Colonial Bank officer created and submitted fictitious loan information to Colonial Bank and created fictitious mortgage-backed securities assembled from the fraudulent loans. By the end of 2007, the scheme consisted of approximately $500 million in fake residential mortgage loans and approximately $1 billion in severely impaired residential mortgage loans and securities. These fictitious and impaired loans were misrepresented as high-quality assets on Colonial BancGroup's financial statements.

The SEC alleges that in addition to causing Colonial BancGroup to misrepresent its assets, Brown assisted Farkas in causing BancGroup to misstate publicly that it had obtained commitments for a $300 million capital infusion that would qualify Colonial Bank for TARP funding. In fact, Farkas and Brown never secured financing or sufficient investors to fund the capital infusion. When BancGroup issued a press release announcing it had obtained preliminary approval to receive $550 million in TARP funds, its stock price jumped 54 percent - its largest one-day price increase since 1983. When BancGroup and TBW later mutually announced the termination of their stock purchase agreement and signaled the end of Colonial Bank's pursuit of TARP funds, BancGroup's stock declined 20 percent.

Brown consented to the entry of a judgment permanently enjoining her from violation of Rule 13b2-1 of the Securities Exchange Act of 1934 and from aiding and abetting violations of Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, 13a-11 and 13a-13 thereunder. The proposed preliminary settlement, under which the SEC's requests for financial penalties against Brown would remain pending, is subject to court approval.

February 24, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Wednesday, February 23, 2011

SEC Secures Emergency Relief in Alleged International Investment Fraud

The SEC filed an emergency action on February 18, 2011 against Secure Capital Funding Corporation, Bertram A. Hill, PP&M Trade Partners, and Kiavanni Pringle, to halt an alleged multi-million dollar international investment scheme that has defrauded investors in the United States and overseas. The Court issued a temporary restraining order freezing assets and ordering repatriation of investor funds.

The SEC alleged that in recent months defendants Secure Capital Funding Corporation, Bertram A. Hill, PP&M Trade Star Partners, and Kiavanni L. Pringle, defrauded investors of millions of dollars through the sale of fictitious Swiss “debentures.” According to the SEC’s complaint, defendants told investors that these securities were “risk-free” and would be used to establish highly leveraged margin accounts to trade other securities, and that investors would earn monthly returns of 10-100%. In reality, according to the SEC, these securities were fictitious and nearly $3 million of investor funds were quickly wired out of the country to accounts in Latvia and Jamaica.

February 23, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

FINRA NAR Rule Impermissibly Retroactive as Applied to Banned Broker

The Ninth Circuit held that a FINRA rule that prohibited non-attorneys who have been banned from the securities industry from representing parties in securities arbitrations was impermissibly retroactive as applied to Richard Sacks, who was banned from the securities industry in 1991.  Since then, according to Sacks, he has represented parties in over 1,300 securities arbitrations.  Sacks v. SEC (No. 07-74647 02/22/11)(Download SacksvSEC).

The Ninth Circuit emphasized the "deeply rooted" presumption against retroactivity in U.S. jurisprudence, based on concerns about fairness.  Relying on its precedent, Koch v. SEC, 177 F.3d 784 (9th Cir. 1999) (finding SEC rule banning participation in penny stock offerings impermissibly retroactive as applied to previously barred broker), it found that the FINRA rule imposed a "new and grave consequence" on Sacks' prior conduct.  The court did not explicitly address FINRA's interest in protecting investors and its forum, although it noted that the rule bars Sacks from participating in activity in which he had previously engaged.

February 23, 2011 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Second Circuit Expands SRO's Absolute Immunity from Private Damages Suits

The Second Circuit, in Standard Investment Chartered, Inc. v. NASD (No. 10-945-cv, 02/22/11)(Download StandardInvCharter), held that NASD and its officers had absolute immunity from a private damages suit alleging misstatements in its proxy solicitation of its members to amend its bylaws in connection with the consolidation of NASD and NYSE to form FINRA.  In so doing, the court, in its short per curiam opinion, reiterated that "there is no question" that an SRO and its officers are entitled to absolute immunity from private damages suits in connection with the discharge of their regulatory responsibilities.  While cautioning that the doctrine "is of a rare and exceptional character," the appellate court expanded the list of instances where an SRO has absolute liability to include amendment of its bylaws where the amendments are inextricable from the SRO's role as a regulator.  The court thought that it was significant that, under federal securities law, NASD could not alter its bylaws without SEC approval and that the SEC retained discretion to amend any SRO rule, thus demonstrating the extent to which an SRO's bylaws are interwined with the regulatory powers delegated to the SROs by the SEC.

February 23, 2011 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Sunday, February 20, 2011

Cunningham on Executive Compensation and Unconscionability

A New Legal Theory to Test Executive Pay: Contractual Unconscionability, by Lawrence A. Cunningham, George Washington University Law School, was recently posted on SSRN.  Here is the abstract:

Lucrative pay to corporate managers remains controversial yet continues to evade judicial scrutiny for legitimacy. Although many arrangements likely would pass the most rigorous scrutiny, it seems equally clear that some would not. Some agreements are not the product of arm’s-length bargaining, can rivet managers on short-term stock prices at the destruction of long-term business value, and can misalign manager-shareholder interests. Yet even such objectionable arrangements are immune from serious legal oversight. In theory, they are open to judicial review under corporate law, but shareholders challenging pay contracts face formidable procedural hurdles in derivative litigation and substantive obstacles from corporation law’s business judgment rule and the anemic doctrine of waste. A new legal theory would be useful to check board excesses in the population of clearly objectionable cases.

This Article explains why and how traditional contract law’s theory of unconscionability should be used to create a modicum of judicial scrutiny to strike obnoxious pay contracts and preserve legitimate ones. Under this proposal, pay contracts that are the product of managerial domination of the process and formed on terms massively favoring the executive will be stricken. This will follow direct shareholder lawsuits in state courts where the contract is made or performed and applying that state’s contract law. This new legal theory circumvents today’s dead-end route, where pay contracts are always upheld in derivative shareholder lawsuits applying corporate law that sets no meaningful limits on executive pay. This proposal creates new but modest pressure from sister states on Delaware to take greater responsibility for the effects its production of corporate law has nationally.

For those outraged by lopsided corporate executive compensation, this Article offers an appealing new legal theory of contractual unconscionability to police them. Those who see no or few problems with contemporary pay arrangements, or who are outraged by federal regulatory schemes like the Dodd-Frank Act, will welcome how this proposal is narrowly tailored using common law to address the most obnoxious cases.

February 20, 2011 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Conti-Brown on Elective Shareholder Liability for Systemically Important Institutions

Elective Shareholder Liability for Systemically Important Financial Institutions, by Peter Conti-Brown, Stanford University, Rock Center for Corporate Governance, was recently posted on SSRN.  Here is the abstract:

Despite the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the initial proposal of Basel III, the debate regarding the regulation of systemically important financial institutions (SIFIs) continues unabated. Prominent among the present proposals is one led by prominent financial economists who argue in favor of 15% capital adequacy requirements for banks. So far, banks and their political supporters have resisted this proposal, claiming that it presents the banks with prohibitive and unnecessary costs. This Article proposes a mechanism, called elective shareholder liability, that provides the shareholders of the largest banks with a way to identify the costs of higher capital adequacy beyond simply the subsidies that come by way of the implicit governmental guarantees that the SIFIs presently enjoy. Elective shareholder liability gives SIFIs the option to subject themselves to the 15% capital adequacy, or, if not, grant a bailout exception to the SIFI’s present limited shareholder liability status. The latter is structured as an obligatory governmental cause of action for the recoupment of all bailout costs against the shareholders, assessed on a pro-rata basis. The cause of action would include an up-front stay on litigation to ensure that there are, in fact, taxpayer losses to be recouped, and to dampen government incentives for over-bailout, political manipulation, and crisis exacerbation. The cause of action would also give the government the authority to declare the shareholders’ use of the corporate form to evade liability null and void. After explaining the structure and benefits of elective shareholder liability, the Article addresses more than a dozen potential objections. Close inspection of these objections, however, reveals that the overall case for elective shareholder liability is strong as a matter of history, law, and economics.

February 20, 2011 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Morley on the Origins of Investment Management Regulation

Collective Branding and the Origins of Investment Management Regulation: 1936-1942, by John Morley, University of Virginia School of Law, was recently posted on SSRN.  Here is the abstract:

This paper examines how market and political forces interacted to create the American mutual fund industry and its regulation between 1936 and 1942. Contrary to previous scholarly work, this paper argues that the key elements of regulation that now differentiate modern mutual funds from modern hedge funds had their origins in lobbying by the mutual fund industry itself, rather than in populist or public-spirited forces in the SEC or the Roosevelt administration. The largest funds desired to maintain an industry-wide brand for a passive, low-risk style of investing and they sought regulation to maintain this brand. They did so even though some investors rationally might have preferred risky or active styles of investing that regulation ultimately prohibited. An understanding of the industry’s brand-building motivations can explain several puzzling features of mutual fund regulation, including restrictions on borrowing, redemption rights and control over portfolio companies. The mutual fund industry was able to achieve strong agreement on how to influence regulation because the industry had grown into its modern shape well before Congress adopted the current regulatory regime. Evidence from mutual funds’ portfolios, for example, shows that no funds that had any chance of being swept up in the mutual fund tax and regulatory regime in the late 1930s had any substantial interest in the governance or control of their portfolio companies. This paper also examines the key distinguishing feature of modern mutual fund taxation - actual, rather than nominal, distribution of income to shareholders - and shows that it may have originated in an attempt by open-end mutual funds to drain assets from closed-end mutual funds.

February 20, 2011 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Palmiter & Taha on Mutual Fund Performance Advertising

Mutual Fund Performance Advertising: Inherently and Materially Misleading?, by Alan R. Palmiter, Wake Forest University - School of Law, and Ahmed Taha, Wake Forest University - School of Law, was recently posted on SSRN.  Here is the abstract:

Mutual fund companies routinely advertise the past returns of their strong-performing, actively-managed equity funds. These performance advertisements imply that the advertised high past returns are likely to continue. Indeed, investors flock to these funds despite high past returns being a poor predictor of high future returns. Thus, fund performance advertising is inherently and materially misleading and violates federal securities antifraud standards. In addition, the SEC-mandated warning in these advertisements that “past performance does not guarantee future results” fails to temper investors’ focus on past returns.

The SEC should do more to prevent investors from being misled by fund performance advertisements. It should at least require a stronger warning that makes clear that high returns by actively-managed mutual funds generally do not persist. The SEC should also seriously consider reinstating its prior prohibition of performance advertisements. Such a ban would help investors focus on more important fund characteristics, such a fund’s costs, risk, and the extent to which the fund’s investment objective matches that of the investor.

February 20, 2011 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Stanford Sues Government Agents for Abusive Law Enforcement

Robert Allen Stanford is, allegedly, the other great purveyor of a ponzi scheme that collapsed during the financial crisis.  In early 2009, shortly after Madoff confessed to his fraud, the SEC raided Stanford's offices in Texas to shut down what regulators described as a massive ongoing fraud.  Stanford has consistently maintained his innocence and blames the government for investors' losses. 

Since his arrest in 2009 he has been incarcerated, and he has not had an easy time of it.  In 2010 he was found to lack the mental capacity to participate in his defense, resulting from a combination of factors, including addiction to drugs and a beating suffered in prison.

Stanford, apparently, is not so mentally incapacitated that he cannot bring a lawsuit and sue those he blames for his troubles -- the government.  In a complaint filed this week, Stanford charges that prosecutors, FBI agents and SEC staff members (no government agency was named as a defendant) engaged in abusive law enforcement.  He seeks $7.2 billion in damages.  NYTimes, Allen Stanford, Indicted Financier, Sues Authorities

February 20, 2011 in News Stories | Permalink | Comments (1) | TrackBack (0)