Securities Law Prof Blog

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

Saturday, July 7, 2012

SEC Charges Axius and CEO with Market Manipulation

The SEC charged Axius, Inc., its President and CEO, Roland Kaufmann, and stock promoter Jean-Pierre Neuhaus with engaging in a fraudulent broker bribery scheme designed to manipulate the market for Axius’ common stock. According to the SEC's complaint, beginning in at least January 2012, Kaufmann and Neuhaus engaged in an undisclosed kickback arrangement with an individual (“Individual A”) who claimed to represent a group of registered representatives with trading discretion over the accounts of wealthy customers. Kaufmann and Neuhaus promised to pay kickbacks of between 26% and 28% to Individual A and the registered representatives he purported to represent in exchange for the purchase of up to $5 million of Axius stock through the customers’ accounts.

The complaint further alleges that on February 16 and 17, 2012, Kaufmann instructed Individual A to purchase approximately 14,000 shares of Axius stock for a total of approximately $49,000 through matched trades using detailed instructions concerning the size, price and timing of the purchase orders. Thereafter, Kaufmann paid Individual A bribes of approximately $13,700.

The Commission seeks permanent injunctive relief, disgorgement of ill-gotten gains, plus pre-judgment interest, and civil penalties from all defendants, an order prohibiting Neuhaus and Kaufmann from participating in any offering of penny stock, and an order prohibiting Kaufmann from serving as an officer or director of a public company.

July 7, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

FINRA's New Suitability Rule Goes into Effect July 9

FINRA's new Know-Your-Customer (Rule 2090) and Suitability (Rule 2111) Rules go into effect on July 9.  The SEC approved the rules in November 2010.  The rules are essentially a reworking of the prior NYSE and NASD rules, but they have engendered some anxiety in the industry.  FINRA delayed the original effective date of Oct. 7, 2011 because members expressed the need for more time to update procedures, modify automated systems and educate associated persons.  FINRA has also issued three Notices providing guidance on the rules' requirements (NTM 11-02, 11-25, 12-25).

So what do the rules require?

New FINRA Rule 2090 (Know Your Customer), based on the prior NYSE Rule, requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer….” For purposes of the rule, essential facts are “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling
instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”

New FINRA Rule 2111 (Suitability), based on the prior NASD rule, requires that a firm or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”  Paragraph (b) of the Rule provides an exemption for institutional accounts.

In the supplementary material to Rule 2111, FINRA explains that "investment strategy" is to be interpreted broadly.  However, certain communications are excluded so long as they do not include a recommendation of any particular security: general financial and investment information, descriptive information about an employee-sponsored retirement or benefit plan, asset allocation models that meet certain requirements, and interactive investment materials that incorporate the above.

The supplementary material also sets forth what FINRA has previously described as the components of the suitability obligation:

    Reasonable-Basis Suitability.  The firm must have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.  Importantly, "[a] member's or associated person's reasonable diligence must provide the member or associated person with an understanding of the potential risks and rewards associated with the recommended security or strategy.  The lack of such an understanding when recommending a security or strategy violates the suitability rule."

    Customer-Specific Obligation.  The firm or associated person must have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer's investment profile.

    Quantitative Suitability addresses excessive trading in a customer's account and requires a firm or associated person who has actual or de facto control over the account to have a reasonable basis for believing that a series of transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together in light of the customer's investment profile.

Why have these rules created anxiety among broker-dealers?  In NTM 11-25, FINRA stated that questions from broker-dealers focused on information-gathering requirements in relation to a customer’s investment profile, the scope of the term “strategy,” and reasonable-basis obligations.  In NTM 12-25, FINRA identified further concerns: the
obligation to act in a customer’s best interests; the scope of the terms “recommendation,” “customer” and “investment strategy”; the use of a risk-based approach to documenting suitability; information gathering requirements; reasonable-basis and quantitative suitability; and the institutional-customer exemption.

FINRA has tried to provide reassurance to members.  In NTM 12-25, for example:

FINRA reiterates, however, that many of the obligations under the new rule are the same as those under the predecessor rule and related case law. Existing guidance and interpretations regarding suitability obligations continue to apply to the extent that they are not inconsistent with the new rule. Furthermore, FINRA appreciates that no two firms are exactly alike. Firms have different business models; offer divergent services, products and investment strategies; and employ distinct approaches to complying with applicable regulatory requirements. FINRA’s guidance is not intended to influence any firm’s choice of a particular business model or reasonable approach to ensuring compliance with suitability or other regulatory requirements.

According to Investment News, the industry is upset because it thinks the suitability standard comes "awfully close" to a fiduciary standard.  InvNews, New Finra suitability rules worry industry 

July 7, 2012 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

FINRA Seeks Comment on Regulation of Crowdfunding Activities

FINRA recently posted on its website a request for public comment on proposed regulation of crowdfunding activities. (Download FINRA.NTM12-34)  The JOBS Act requires that intermediaries performing crowdfunding on behalf of issuers must register with the SEC as a "funding portal" or broker and must register with an applicable SRO.  FINRA seeks comment on the appropriate scope of FINRA rules that should apply to member firms engaged in crowdfunding activities.

As FINRA noted in its Notice to Members:

The regulatory scheme established by Congress expressly contemplates a role for an organization such as FINRA by mandating that each registered funding portal be a member of an applicable SRO. However, Congress limited a national securities association’s examination and enforcement authority over such registered funding portals to its rules
“written specifically for registered funding portals.”

Accordingly, FINRA seeks comment on two categories of rules: those that would apply specifically to members acting as funding portals and those applicable to members acting as brokers.  According to the Notice:

In writing rules specifically for registered funding portals, FINRA would seek to ensure that the capital-raising objectives of the JOBS Act are advanced in a manner consistent with investor protection. Commenters are encouraged to identify the types of requirements that should apply to registered funding portals, taking into account the relatively limited scope of activities by a registered funding portal permitted under the JOBS Act. Comments are particularly requested about possible rules concerning supervision, advertising, anti-money laundering, fraud and manipulation, and just and equitable principles of trade.

FINRA also solicits comment on the application of existing FINRA rules to crowdfunding activities of broker-dealers. Unlike the rules applicable to registered funding portals, the JOBS Act does not limit the FINRA rules applicable to registered broker-dealers engaging in crowdfunding activities. Nevertheless, FINRA invites comments from broker-dealers regarding the application of existing FINRA rules to broker-dealers’ crowdfunding activities and whether such rules should be relaxed to address a broker-dealer’s crowdfunding activities, taking into account, among other things, the extent to which a broker-dealer may be able to isolate its crowdfunding business, or otherwise places limitations on its activities akin to those for registered funding portals. FINRA requests information from broker dealers that may engage in crowdfunding concerning the organizational structure through which this activity would occur within the firm (e.g., through the broker-dealer entity or a separately identified department). FINRA also requests comment on whether engaging in crowdfunding might present special conflicts or concerns for a broker-dealer, such as might arise if a registered representative were to recommend that a customer visit the firm’s crowdfunding site.

Comments are due by August 31.


July 7, 2012 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

Thursday, July 5, 2012

Second Circuit Affirms $20.5 Million Arbitration Award Against Ponzi Scheme's Clearing Firm

The Second Circuit summarily affirmed a district court's confirmation of a $20.5 million arbitration award against Goldman Sachs Execution & Clearing L.P.  The claimants, the unsecured creditors committee of Bayou Group, LLC, asserted that the clearing firm had "red flags" to alert them that Bayou was in fact a Ponzi scheme.  Goldman Sachs unsuccessfully argued that the award was "in manifest disregard of the law."  The Second Circuit, noting that the manifest disregard standard is, by design, exceedingly difficult to satisfy, agreed with district court that Goldman had not satisfied it.  Goldman Sachs Execution & Clearing, L.P. v. Official Unsecured Creditors' Committee of Bayou Group LLC (2d Cir. July 3, 2012).

July 5, 2012 in Judicial Opinions, Securities Arbitration | Permalink | Comments (0) | TrackBack (0)

Sixth Circuit: Lawyers Performing Ordinary Legal Work are not Statutory Sellers under Kentucky Statute

The Sixth Circuit recently held that an attorney who performs traditional legal services for a company offering its securities to the public cannot be held liable as an offeror or seller of the securities or as an agent of the seller who materially aids the sale of securities, under the Kentucky securities statute.  Bennett v. Durham (6th Cir. June 28, 2012).  (Download BennettvDurham)

Durham was an attorney who represented two oil and gas exploration companies in connection with their sales of securities, including drafting the documents for the deals.  He also made himself available to answer prospective investors' questions, all the while, according to plaintiffs, knowing that the documents contained material misstatements and that the securities were neither registered nor exempt from registration.  The court relied on Pinter v. Dahl, 486 U.S. 622 (1988) and determined that there was no reason to think that Kentucky courts would construe the words differently.  The court emphasized that plaintiffs did not allege any facts that would show that Durham performed any services other than "ordinary legal work securities lawyers do every day."  Plaintiffs "cite no case holding an attorney liable under the Uniform Securities Act merely for drafting documents, providing advice and answering client questions." 

July 5, 2012 in Judicial Opinions, State Securities Law | Permalink | Comments (0) | TrackBack (0)

Claims Court Allows Former Controlling Shareholder of AIG to Sue Government

Starr International Company, which was the controlling shareholder of AIG before the federal bailout, sued the U.S. government on a variety of theories.  Essentially it asserted that the government, rather than providing liquidity support offered to other financial institutions, exploited AIG's vulnerable financial situation by becoming the controlling lender and controlling shareholder in September 2008.  According to Starr, the government took control of AIG so that it could use the corporation and its assets to provide a "backdoor bailout" to other financial institutions and that the government took AIG's property without due process or just compensation.  On July 2, the U.S. Court of Federal Claims granted in part and denied in part the government's motion to dismiss the claims.  It also deferred the issue of whether Starr adequately pled a demand on AIG's board or the futility of such a demand.  The government is required to file an answer by July 16.  (Download StarrvsUS11212011[1]

July 5, 2012 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Court Rejects SEC's Broad Definition of Customers: Stanford Investors Out of Luck

As I previously blogged, on July 3 the federal district court (D.C.) denied the SEC's application for an order compelling SIPC to commence a liquidation proceeding to protect customers who purchased CDs issued by an Antiguan bank marketed by the Stanford Group Company, a now-defunct broker-dealer that was a member of SIPC.  I now have read the court's opinion which concludes that the SEC failed to meet its burden of proving that SIPC "has refus[ed] ... to commit its funds or otherwise to act for the protection of customers of any member of SIPC."  (Download SECvSIPC)

While expressing sympathy to the plight of the Stanford customers who purchased the CDs, the court noted its duty to apply the statute as written by Congress.  The key issue in the dispute is whether the persons who purchased the CDs were "customers" of SGC within the meaning of the statute.  The court reviews the law and finds it well-settled that "the critical aspect of the 'customer' definition is the entrustment of cash or securities to the broker-dealer for the purpose of trading securities."  To prove entrustment, the claimant must prove that the SIPC member actually possessed the claimant's funds or securities.  Pursuant to facts stipulated by the parties, the SEC cannot show that SGC ever physically possessed the investors' funds at the time that the investors made their purchases.  The investors wrote checks or wired funds to the bank for the purpose of buying the CDs; the funds were never deposited into a SGC account.  Under a literal meaning of the statute, the investors were not customers of SGC.  The court declined the SEC's invitation to adopt a broader construction of the statute, finding that it did not square with the agency's longstanding interpretation of SIPA and was contrary to the statutory language.

July 5, 2012 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Tuesday, July 3, 2012


Readers may recall that the SEC sued SIPC to force it to pay investors in Allen Stanford's Ponzi scheme.  SIPC maintained it could not pay them because the investors did not lose money in a failed brokerage, the purpose of SIPA insurance, but because they purchased CDs from an Antiguan bank.   Although initially the SEC agreed with SIPC's position, it subsequently changed its mind and brought this law suit.  Today, the WSJ reports, a federal district court in D.C. ruled that the SEC failed to meet its burden in proving that the victims were eligible under the statute.  The SIPC CEO, in a statement, emphasized that it felt its hands were tied because of narrow purpose of the statute -- to ensure custody of customer funds.

WSJ, SEC Loses Bid to Get SIPC to Pay Stanford Ponzi Claims

July 3, 2012 in News Stories, SEC Action | Permalink | Comments (0) | TrackBack (0)

GAO: Will JOBS Act Increase Number of Reg A Offerings?

The GAO issued a report on Factors That May Affect Trends in Regulation A Offerings (GAO-12-839, Jul 3, 2012), a timely topic since the JOBS Act increased the cap for Reg A offerings from $5 million to $50 million.  This is what the GAO found:

The number of Regulation A offerings filed and qualified (that is, cleared) by the Securities and Exchange Commission (SEC) has declined significantly after peaking in fiscal years 1997 and 1998, respectively. In particular, offerings filed since 1997 decreased from 116 in 1997 to 19 in 2011. Similarly, the number of qualified offerings dropped from 57 in 1998 to 1 in 2011. Securities attorneys GAO interviewed suggested that the decrease in filings after 1997 could be attributed to a number of factors, including the increased attractiveness of Regulation D. The National Securities Markets Improvement Act of 1996 preempted state registration requirements for other categories of securities including certain Regulation D offerings, which are also exempt from SEC registration. In contrast, Regulation A offerings are generally subject to state securities laws and must go through a federal filing and review process. In recent years, businesses have used Regulation D and registered public offerings to a greater extent than Regulation A.

*    *    *

Multiple factors appear to have influenced the use of Regulation A and views vary on whether raising the offering threshold will increase its use. The factors included the type of investors businesses sought to attract, the process of filing the offering with SEC, state securities laws, and the cost-effectiveness of Regulation A relative to other SEC exemptions. For example, identifying and addressing individual state’s securities registration requirements can be both costly and time-consuming for small businesses, according to research, an organization that advocates for small businesses, and securities attorneys that GAO interviewed. Additionally, another SEC exemption is viewed by securities attorneys that GAO met with as more cost-effective for small businesses. For example, through certain Regulation D filings small businesses can raise equity capital without registering securities in individual states, as long as other requirements are met. State securities administrators, a small business advocate, and securities attorneys with whom GAO met had mixed views on whether the higher maximum offering amount ($50 million) under the JOBS Act would lead to increased use of Regulation A. For example, some thought that the higher threshold could encourage greater use of Regulation A, while others told us that many of the factors that have deterred its use in the past likely will continue to make other options more attractive.


July 3, 2012 in Other Regulatory Action | Permalink | Comments (2) | TrackBack (0)

Monday, July 2, 2012

SEC Will Take Up JOBS Act Changes to Rules 506 and 144A

At its next Open Meeting on August 22, the SEC will consider rules to eliminate the prohibition against general solicitation and general advertising in Rule 506 and Rule 144A offerings, as mandated by the JOBS Act.

Other items include:

  • whether to adopt rules regarding disclosure and reporting obligations with respect to the use of conflict minerals to implement the requirements of Section 1502 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
  • whether to adopt rules regarding disclosure and reporting obligations with respect to payments to governments made by resource extraction issuers to implement the requirements of Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

July 2, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

FINRA Launches Pilot Program for Large Arbitration Cases

FINRA announced the launch of a pilot program specifically designed for large arbitration cases involving claims of $10 million or more. The program enables parties to customize the administrative process to better suit special needs of a larger case and allows them to bypass certain FINRA arbitration rules. Participation in the pilot program, which began today, is voluntary and open to all cases; but in order to be eligible, all parties will be required to pay for any additional costs of the program and must be represented by counsel.

FINRA gives some examples how parties may customize the process:

have additional control over the method of arbitrator appointment and the qualifications of arbitrators;
hire non-FINRA arbitrators for their case;
develop their own procedures for exchanging information prior to the hearing;
have expanded discovery options such as depositions and interrogatories; and
choose from a wider selection of facilities.

July 2, 2012 in Other Regulatory Action, Securities Arbitration | Permalink | Comments (0) | TrackBack (0)