Wednesday, May 30, 2012
SEC v. Goble (11th Cir. May 29, 2012) addresses the issue of what constitutes "securities fraud" under rule 10b-5 in the context of a clearing firm's fudging its books and records to meet regulatory reserve requirements. To my astonishment, the appellate court decided that the principal of a clearing firm did not commit securities fraud when he caused the firm to enter on its records a sham transaction purporting to be a $5 million money market purchase because, according to the court, "a misrepresentation that would only influence an individual's choice of broker-dealers cannot form the basis for 10(b) securities fraud liability." ( Download SECv.Goble )
First, the facts: Richard Goble controlled North America Clearing, Inc., a clearing broker for about forty small brokerage firms. In 2007-2008 the firm had financial difficulties and struggled to maintain at the appropriate level the cash reserve account required by SEC regulations. Finally, in May 2008, Goble directed the CFO to record a sham transaction -- $5 million money market purchase -- to make it appear that firm could withdraw $3.4 million from the reserve account. FINRA examiners, who were on site, quickly discovered the sham transaction; within a few days, it was clear that the firm could not meet the reserve requirements, and the firm was wound down. An SEC enforcement action followed, charging that the firm violated the customer protection rule and books and records requirements. It also charged Goble with violating Rule 10b-5 (in addition to aiding and abetting the firm's violations). The district found against Goble on both counts, enjoined him from future violatons of the securities laws and permanently restrained him from seeking a securities license or engaging in the securities business. The appeals court reversed the district court's judgment on the 10(b) count, upheld the judgment on the aiding and abetting count and remanded for reconsideration of the injunctive relief and the bar.
Second, the appellate court's analysis of the 10(b) claim: The SEC based its 10(b) claim on Goble's causing the CFO to record the fake money market fund purchase in the firm's books. The appellate court first rejected the district court's finding that this was a material misrepresentation. It "easily dispatch[ed] the ... theory that the sham transaction would have been material to an investor's choice of broker-dealers," because the materiality test focuses on the importance of the fact on an investment decision -- which the court believes does not include an investor's choice of broker-dealer. The court categorically states that "a misrepresentation that would only influence an individual's choice of broker-dealers cannot form the basis for a 10(b) securities fraud liability." The appellate court also found that the misrepresentation was not made "in connection with the purchase or sale of securities," even though it assumed, without deciding, that the money market fund was a security. (The district court had found that a money market fund was not a security, another curious assertion.) Since the only "purchase" was a sham transaction, it was neither a "purchase" nor the type of behavior that 10(b) forbids. Indeed, another categorical assertion by the court: "Section 10(b) was not intended to protect investors from a broker-dealer's inaccurate records or an inadequate reserve fund."
As noted, the count against Goble for aiding and abetting the customer protection rule and books and records regulations was upheld, although the district court was directed to reconsider the remedy and determine if a bar is an appropriate remedy. Nonetheless, it is discouraging to read that information that would affect an investor's choice of broker-dealer is not material because it does not relate to an investment decision. I just hope that the reach of this opinion is confined to its particular facts and the sweeping assertions do not come back to bite investors who rely to their detriment on brokers' assertions of their competence, expertise and probity.