Securities Law Prof Blog

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

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Friday, September 7, 2012

Black & Gross on Investor Protection and the FAA

Investor Protection Meets the Federal Arbitration Act, by Barbara Black, University of Cincinnati - College of Law, and Jill Gross, Pace Law School, was recently posted on SSRN.  Here is the abstract: 

In the past three decades, most recently in AT&T Mobility LLC v. Concepcion, the United States Supreme Court has advanced an aggressive pro-arbitration campaign, transforming the Federal Arbitration Act (FAA) into a powerful source of anti-consumer substantive arbitration law. In the aftermath of AT&T Mobility, which upheld a prohibition on class actions in a consumer contract despite state law that refused to enforce such provisions on unconscionability grounds, efforts have been made to prohibit investors from bringing class actions or joining claims, including claims under the Securities Exchange Act of 1934 (the Exchange Act). In the most egregious example to date, the broker-dealer Charles Schwab & Co. (Schwab) revised its customer account agreements to prohibit class actions and joinder of claims. When the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization for broker-dealers, brought a disciplinary action against Schwab, claiming the revision violated FINRA rules, the broker-dealer sued FINRA, asserting that the FAA requires enforcement of its arbitration agreement. This confrontation provides a concrete opportunity to analyze how courts should resolve conflicts between the FAA and federal regulatory statutes designed to protect certain segments of the public, in this case, investors.

This article addresses whether the FAA limits the ability of federal regulators acting pursuant to Congressional authority to impose conditions and limitations on the use of arbitration provisions in order to ensure fairness. In this article, we summarize current Supreme Court FAA jurisprudence that establishes a strong national pro-arbitration policy. We then describe the Exchange Act’s regulation of arbitration involving broker-dealers, specifically the authority delegated to the SEC and FINRA to regulate the content of arbitration clauses in broker-dealer/customer contracts and the Exchange Act’s anti-waiver provision barring any condition that forces investors to waive compliance with any part of the Exchange Act, its rules and SRO rules. After detailing the current regulatory dispute between Schwab and FINRA over Schwab’s inclusion of a class action waiver in its customer agreement, we argue that courts should resolve the conflict between the FAA and the Exchange Act by applying the Exchange Act over the FAA through the long-standing doctrine of implied repeal, additional well-accepted canons of statutory construction, and current Exchange Act and FAA jurisprudence.
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September 7, 2012 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

SEC Obtains Asset Freeze Against San Diego Real Estate Investment Fraud

The SEC announced an asset freeze against a San Diego-based firm and its owner accused of running a real estate investment fraud that raised approximately $50 million from hundreds of investors nationwide.  The SEC alleges that Western Financial Planning Corporation and Louis V. Schooler sold units in partnerships that Western had organized to buy vacant land in Nevada and hold for sale at a profit at a later date. Schooler and Western failed to tell investors that they were paying an exorbitant mark-up on the land, in some cases more than five times its fair market value. Schooler and Western also failed to tell investors that the land held by the partnerships was often encumbered by mortgages that Western used to help finance the initial purchase of the land.

The Honorable Larry A. Burns for the U.S. District Court for the Southern District of California yesterday granted the SEC’s request for a temporary restraining order and asset freeze against Schooler, Western, and all entities under Western’s control, and appointed Thomas C. Hebrank as a temporary receiver over Western and the entities. Judge Burns has scheduled a court hearing for Sept. 17, 2012, on the SEC’s motion for a preliminary injunction.

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

SEC Reschedules Market Technology Roundtable

The Securities and Exchange Commission today announced that its market technology roundtable, which was scheduled for Sept. 14, will be held on Oct. 2. The change was made to accommodate scheduling conflicts and to better respond to strong interest from individuals and groups wishing to participate in the roundtable discussion.

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

Solar Manufacturer Settles SEC Charges About Concealing Agreement to Transfer Ownership Interest in Chinese Sub

The SEC settled charges that Worldwide Energy and Manufacturing USA Inc. (WEMU), a solar panel manufacturer headquartered in South San Francisco, and three of its former executives defrauded investors by concealing the transfer of nearly half of the ownership stake in its Chinese subsidiary to three individuals in China who manage the subsidiary.

The SEC alleges that WEMU raised nearly $9 million from U.S. investors in early 2010 in order to expand its solar subsidiary based in Rugao City, China. The Chinese subsidiary represented the bulk of WEMU’s operations and generated 77 percent of the company’s revenue the previous year. In a power point presentation at road shows and in other communications with investors, the company’s founder and chairman of the board Jimmy Wang and the company’s president Jeffrey Watson touted the solar subsidiary’s success as the primary growth area for the company and represented that the company fully owned its Chinese subsidiary. They neglected to tell investors that WEMU actually was set to transfer 49 percent of the equity in the Chinese subsidiary to its three managers. In February 2009, Jimmy Wang signed two key agreements on behalf of WEMU to share 49 percent of the Chinese subsidiary’s net profits with the solar managers and to transfer 49 percent of the subsidiary’s equity to them in February 2010. Failure to disclose these agreements resulted in WEMU filing false and misleading quarterly reports for the first three quarters of 2009 and first quarter of 2010.

Without admitting or denying the SEC’s allegations, WEMU agreed to pay a $100,000 penalty and be permanently enjoined from future violations of antifraud, reporting, books and records and internal controls provisions of the federal securities laws. The Wangs and Watson consented to permanent bars from serving as officers or directors of a public company and agreed to be permanently enjoined from future violations of the antifraud and other provisions of the federal securities laws. Mindy Wang and Watson each agreed to pay penalties of $50,000. The terms of the settlement with Jimmy Wang reflect credit given to him by the Commission for his substantial assistance in the investigation and the fact that he has entered into a cooperation agreement to assist in the ongoing investigation.

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

Thursday, September 6, 2012

Second Circuit Revives Insider Trading Case Against Hedge Fund Manager

The Second Circuit revived an insider trading case brought by the SEC against Nelson Obus, a New York hedge fund manager.  The SEC charged that Obus received a stock tip from Thomas Strickland, a former employee at GE, that Sunsource was about to be acquired by Allied Capital.  GE was looking into financing the acquisition.  The federal district court had dismissed the case in late 2010, ruling that neither Strickland nor GE was a corporate insider of SunSource and that the SEC had not "demonstrated the requisite degree of deceptive conduct on the part of any defendant."

The Appeals Court, however, disagreed and stated that the SEC "has established genuine questions of fact about whether Obus knew that Strickland had breached a duty to GE Capital and whether Obus traded in SunSource stock while in knowing possession of material non-public information...."

NYTimes, Appeals Court Revives Insider Trading Case Against Obus

September 6, 2012 in News Stories | Permalink | Comments (0) | TrackBack (0)

SEC Charges Investment Adviser with Failing to Disclose Revenue-Sharing Payments

The SEC instituted a settled administrative proceeding against two Portland, Oregon-based investment advisory firms and their owner Christopher Keil Hicks for failing to disclose a revenue-sharing agreement and other potential conflicts of interest to clients.  The SEC’s investigation found violations in three areas of the advisory business run by Hicks, who owns Focus Point Solutions and The H Group. Most notably, Focus Point did not disclose to customers that it was receiving revenue-sharing payments from a brokerage firm that managed a particular category of mutual funds being recommended to Focus Point clients.   Without admitting or denying the SEC’s charges, Hicks, Focus Point, and The H Group agreed to pay a combined $1.1 million to settle the case.

The SEC's release goes on to state that the Asset Management Unit and the SEC’s San Francisco Regional Office have commenced an initiative to shed more light on revenue-sharing arrangements between investment advisers and brokers.

September 6, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Charges PR Executive with Insider Trading in Client's Stock

The SEC settled charges that Renee White Fraser, the CEO of a Los Angeles-based public relations firm, traded on nonpublic information she learned from a client that was about to acquire a bank.  The SEC alleges that Fraser was contacted by Pasadena-based East West Bancorp (EWBC) for marketing and public relations support during its acquisition of San Francisco-based United Commercial Bank. The very next day after agreeing to take on EWBC as a client, Fraser bought 10,000 shares of EWBC stock. She sold all of her shares after EWBC’s stock price jumped 55 percent after the public announcement of the acquisition.  Fraser agreed to settle the SEC’s charges by paying $91,530.36, which is more than double what she gained in illegal profits from her alleged insider trading.

September 6, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Emails Show How the Revolving Door Spins at the SEC

Bloomberg Business Week has a not-to-be-missed article exploring the "revolving door" at the SEC.  It obtained through a FOIA request emails between Annette Nazarath, a former SEC Commissioner now at Davis Polk, and various SEC officials, including Chairman Mary Schapiro and former General Counsel David Becker.  The emails do not show any improper conduct, but nevertheless provide further evidence that big name law firms who employ former SEC officials can provide their clients with influence and access unavailable to the rest of us.  Business Week, Top Bank Lawyer’s E-Mails Show How SEC's Door Spins

September 6, 2012 in News Stories | Permalink | Comments (0) | TrackBack (0)

Wednesday, September 5, 2012

SEC Charges Florida Attorney with $27.5 Million Investment Fraud

The SEC charged an attorney and two others living in South Florida for their roles in a $27.5 million investment scheme that led investors to believe they were purchasing securities consisting of “pre-sold” commodities contracts with a pre-determined profit. However, the supposed profits actually distributed to investors were largely taken from other investors’ funds.

The SEC halted the scheme last year when it obtained an asset freeze and a court-appointed receiver over the companies involved: Commodities Online LLC and Commodities Online Management LLC. The SEC’s follow-up charges are against the founder and former president of the company, James C. Howard III, as well as the company’s vice president Louis N. Gallo III and outside counsel Michael R. Casey, who later became the president.

In a parallel action, the U.S. Attorney’s Office for the Southern District of Florida today announced criminal charges against Howard, Gallo, and Casey.

According to the SEC’s complaint, Commodities Online offered investors the chance to participate in its purportedly profitable brokering of physical commodities via pre-sold contracts – for example, the purchase and sale of large amounts of seafood or iron ore. Investors were sold participation units in unregistered private placement offerings, each supposedly tied to a commodities transaction in which Commodities Online had already secured a buyer and a seller of the commodity. These participation units would purportedly generate predetermined profits for investors.

The SEC alleges that in reality, Commodities Online performed only a limited percentage of the commodities transactions that were promised to investors. The majority of “profits” allocated or distributed to investors were not profits from completed commodities transactions, but instead taken from the funds of other investors. Meanwhile, Howard and Gallo were dissipating millions of dollars in investor funds to largely sham companies. Through these companies, Howard and Gallo stole investor funds for their own use.

According to the SEC’s complaint, Howard stepped down as the company’s president in 2010 after he was arrested for an unrelated investment fraud. He was replaced by Casey, who misled investors about Howard’s continuing control over Commodities Online while also misrepresenting the profitability, structure, and existence of the purported commodities contracts to investors. Casey also failed to tell at least one investor that the funds raised from the purchase of membership interests had previously been misappropriated by Howard.

The SEC alleges that Gallo ran an in-house “boiler room” of telephone sales agents and a network of approximately 20 regional and international sales offices. He failed to disclose to investors that he previously pled guilty to federal bank fraud and other felonies and was serving a term of supervised release while employed at Commodities Online. Gallo also misled investors about Howard’s role at Commodities Online.

The SEC is seeking disgorgement of ill-gotten gains plus prejudgment interest, financial penalties, and permanent injunctions against Howard, Gallo, and Casey. The SEC’s complaint also names several relief defendants for the purposes of recovering investor money steered to those entities in the scheme: Sutton Capital LLC, J&W Trading LLC, American Financial Solutions LLC, and Minjo Corporation.

September 5, 2012 in SEC Action | Permalink | Comments (1) | TrackBack (0)

SEC Charges Radio Personality with Conducting Misleading Investment Seminars

The SEC charged Ray Lucia, Sr., a nationally syndicated radio personality and financial advice author, with spreading misleading information about his “Buckets of Money” strategy at a series of investment seminars that he and his company hosted for potential clients.  According to the SEC, Lucia claimed that the wealth management strategy he promoted at the seminars had been empirically “backtested” over actual bear market periods. Lucia allegedly presented a lengthy slideshow at the seminars indicating that extensive backtesting proved that the Buckets of Money strategy would provide inflation-adjusted income to retirees while protecting and even increasing their retirement savings. However despite the claims they made publicly, Lucia and his company RJL performed scant, if any, actual backtesting of the Buckets of Money strategy.

According to the SEC’s order, a backtest must utilize actual data from the time period in order to get an accurate result. Lucia and RJL have admitted during the SEC’s investigation that the only testing they actually performed were some calculations that Lucia made in the late 1990s – copies of which no longer exist – and two two-page spreadsheets.

According to the SEC’s order, the two cursory spreadsheets that Lucia claims were backtests used a hypothetical 3 percent inflation rate even though this was lower than actual historical rates. Lucia admittedly knew that using the lower hypothetical inflation rate would make the results look more favorable for the Buckets of Money strategy. These alleged backtests also failed to account for the negative effect that the deduction of advisory fees would have had on the backtesting of their investment strategy, and their “backtesting” did not even allocate in the manner called for by Lucia’s Buckets of Money strategy. The slideshow presentation that Lucia and RJL used during the seminars failed to disclose the flaws in their alleged backtests and was materially misleading.

According to the SEC’s order, Lucia and RJL also failed to maintain adequate records of the backtesting as they were required to do under an SEC rule. The pair of two-page spreadsheets was the only documentation of their backtesting calculations, and those spreadsheets failed to duplicate their advertised investment strategy.

The SEC’s order finds that RJL violated Sections 206(1), 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-1(a)(5) thereunder. The order finds that Lucia willfully aided and abetted and caused RJL’s violations of Sections 206(1), 206(2) and 206(4) of the Advisers Act and Rule 206(4)-1(a)(5) thereunder. The SEC’s Division of Enforcement is seeking financial penalties and other remedial action in the proceedings.

September 5, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Charges Poker Buddy with Tipping Hedge Fund Manager about Nvidia's Earnings

The SEC charged a California man with illegally tipping a hedge fund manager with inside information about Nvidia Corporation’s quarterly earnings that he learned from his friend who worked at the company.  According to the SEC, Hyung Lim received $15,000 and stock tips about a pending corporate acquisition for regularly providing a fellow poker player, Danny Kuo, with nonpublic details ahead of Nvidia’s quarterly earnings announcements.  Kuo, a hedge fund manager, illegally traded on the information and passed it on to multi-billion dollar hedge fund advisory firms Diamondback Capital Management LLC and Level Global Investors LP.  The SEC charged Kuo and the firms among others earlier this year as part of its widespread investigation into the trading activities of hedge funds.

In a parallel action, the U.S. Attorney for the Southern District of New York today announced criminal charges against Lim.

According to the SEC’s complaint filed in federal court in Manhattan, Kuo and the hedge funds made nearly $16 million trading in Nvidia securities based on Lim’s inside information.  

September 5, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Tuesday, September 4, 2012

SEC Charges Chinese Issuer with Phony Sales Revenues

The SEC charged China Sky One Medical Inc. (CSKI), a China-based company, and its chief executive with fraud for recording fake sales of a weight loss product to inflate revenues in the company’s financial statements by millions of dollars.  The SEC alleges that  CSKI falsely stated in 2007 annual and quarterly reports that it had entered into a strategic distribution agreement with a Malaysian company that would become the “exclusive” distributor of CSKI’s “slim patch” in Malaysia and generate $1 million per month in sales.  However, the company never actually entered into any such agreement.  CSKI instead created approximately $19.8 million in phony export sales to Malaysia that were recorded as revenue in its financial results for 2007 and 2008.  CEO Yan-qing Liu certified the overstated financial results, which appear in CSKI’s financial statements through 2010 and continue to impact the company’s retained earnings on its balance sheet. 

According to the SEC’s complaint, CSKI is based Harbin, China.  In addition to weight loss patches, the company produces and sells sprays, ointments, and other Chinese traditional pain relief and health and beauty products.  CSKI became a public company trading on the U.S. markets through a reverse merger in May 2006.

The SEC’s complaint seeks financial penalties against CSKI and Liu as well as disgorgement of ill-gotten gains by Liu, who personally benefited from the overstated financial statements through the company’s 2008 private placement of securities.  The SEC also seeks to have Liu reimburse CSKI for certain incentive-based compensation he received during the period affected by the fraud pursuant to Section 304 of the Sarbanes-Oxley Act, and to have Liu barred from acting as an officer or director of a public company.  The SEC also seeks to have CSKI and Liu permanently enjoined from future violations of these provisions of the federal securities laws

In addition to the court action, the SEC instituted administrative proceedings to determine whether to revoke or suspend registration of CSKI’s securities due to the company’s failure to file its annual report for 2011 or any quarterly reports for 2012.

September 4, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Issues Alert on "Pay-to-Play" Prohibitions

The SEC issued a Risk Alert regarding practices that raise concerns about firms' compliance with a Municipal Securities Rulemaking Board rule that limits political contributions by municipal securities professionals to campaigns of public officials of issuers with whom they are doing or seek to do business (so-called “pay to play” practices). These concerns include:

  • Compliance with the rule’s ban on doing business with a municipal issuer within two years of a political contribution to officials of the issuer by any of the firm’s municipal finance professionals
  • Possible recordkeeping violations
  • Failure to file accurate and complete required forms with regulators regarding political contributions
  • Inadequate supervision

The Risk Alert also identifies practices that examiners have seen some firms use to comply with applicable federal, state, and local rules on contributions.

September 4, 2012 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Sunday, September 2, 2012

Haslem on Mutual Fund Revenue Sharing

Revenue Sharing Behind the Mutual Fund Curtain, by John A. Haslem,
University of Maryland - Robert H. Smith School of Business, was recently posted on SSRN.  Here is the abstract:

The objective of this study is to take some of the mystery out of mutual fund revenue sharing, but without being able to say that investors have transparent disclosure. Topics include the transition of directed brokerage to revenue sharing, with the pros and cons for funds and brokers. The discussion of revenue sharing payments includes their general nature, "distribution with a difference," and types of payments. Next, are brief discussions of Charles Schwab's revenue sharing arrangements, SEC findings of illegal undisclosed revenue sharing by Edward D. Jones & Company, and the lack of court protections for shareholders charging funds with excessive fees. Finally, traditional versus "defensive 12b-1 plans" are discussed, of which the latter are used to hedge any charges of illegal fund revenue sharing distribution.

It appears that most in the world of regulation and practice of revenue sharing lacks clarity, consistency, proper redress and investor transparency, such as the supposed "direct distribution" of fund adviser revenue sharing payments from fund adviser "profits" that in practice are likely melded in fund management fees and paid to fund advisers as "indirect distribution."

September 2, 2012 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Gadinis on Politics in Financial Regulation

From Independence to Politics in Financial Regulation, by Stavros Gadinis, University of California, Berkeley - School of Law, was recently posted on SSRN.  Here is the abstract: 

Independent agencies have long dominated the institutional structure of financial regulation. But after the 2007-08 crisis, this Article argues, the independent agency paradigm is under attack. To monitor financial institutions more thoroughly and address future failures more effectively, the U.S. and other industrialized nations redesigned the framework of financial regulation. Post-2008 laws allocate new powers not to independent bureaucrats, but to elected politicians and their direct appointees.

To document this global paradigm shift, the Article examines the laws of fifteen key jurisdictions for international banking: the U.S., the U.K., France, Germany, Japan, Spain, Switzerland, Belgium, Ireland, Italy, Denmark, Canada, Australia, Mexico, and South Korea. This analysis points to a marked increase in the influence of elected politicians over banking. Politicians’ new powers extend not only over emergencies, but also over financial institutions’ regular operations. Politicians are now at the helm of innovative institutional arrangements, typically in the form of regulatory councils that encompass pre-existing independent agencies. In these councils, supermajority requirements and veto rights designate politicians as the ultimate decision-makers.

The Article shows how this paradigm shift resulted from the interplay of factors unique to the 2008 crisis and long run trends. The collapse of institutions in diverse areas of financial activity, including investment banks, insurance companies, and thrifts, created a sense that independent regulators as a class had failed. Concerns about regulatory capture, combined with disillusionment with the markets’ potential to self-correct, further undermined confidence in past paradigms. Developments in financial markets attracted great interest from ordinary Americans, who over the last two decades have increasingly relied on the financial system for their pension savings, housing credit, and other investments. Politicians could not remain as distant from financial regulation as in the past.

From a normative standpoint, politicians’ greater involvement in financial regulation is in line with calls for enhanced presidential control over independent agencies. Scholars have argued that the President’s stamp of approval will increase accountability and boost the legitimacy of hard choices, such as bank bailouts. However, greater political involvement might endanger financial stability, this Article argues. Electoral strategizing can influence politicians’ bailout choices, as incumbents might be particularly sensitive to upheavals as elections approach. Politicians are also under pressure from groups at ideological extremes, which often express a deep distrust to the financial system. In this climate, financial institutions are likely to lobby politicians more intensely. Thus, the risk of a financial catastrophe may now hinge upon considerations that have little to do with the health of the financial system.

September 2, 2012 in Law Review Articles | Permalink | Comments (1) | TrackBack (0)

Colesanti on Ponzi Schemes and Securities Fraud

Another Madoff Masquerade?: Questioning 'Securities Fraud' in the Crime and Its Cleanup, by Scott Colesanti, Hofstra University - School of Law, was recently posted on SSRN.  Here is the abstract:

In December 2008, broker-dealer CEO Bernard Madoff confessed to a massive Ponzi scheme. Days later, he was charged by the Securities and Exchange Commission and the United States Attorney for, among other things, securities fraud. The theory of prosecution proceeded on the premise that Madoff’s illicit investment advisory activities (which stemmed from his reputation in the industry) operated wholly apart from his broker-dealer activities. Subsequently, both the SEC and FINRA (the industry’s largest self-regulator) concluded studies affirming that no securities transactions took place at the broker-dealer– for years, the man with the famous investment firm and his employees had simply spent the cash. Nonetheless, in remedy, the Securities Investor Protection Corporation commenced the process of marshalling all of Madoff’s broker-dealer assets for reimbursement of his Ponzi scheme victims.

Accordingly, this Article examines two crucial, related determinations made in the aftermath of the Madoff scandal: 1) the decision to charge a Ponzi scheme as a violation of SEC Rule 10b-5, and 2) the decision to reimburse certain investors in the Ponzi scheme with SIPC funds. Those determinations are at best debatable given the “pooled fund” nature of the fraud, the complete absence of investment activity, and the near-complete absence of brokerage-house custody of most of the fraud’s assets.

Specifically, while case law from certain Circuits supports the notion that, under certain circumstances, a non-purchase of a security can equate with a purchase/sale for purposes of Rule 10b-5, such an expansive reading of the anti-fraud prohibition seems to greatly expand upon the Supreme Court’s reasoning whence last taking up the cause. And while can SIPC reimbursement under the Securities Investor Protection Act is somewhat discretionary, the decision to reimburse Madoff investors and not those of a contemporaneous billion dollar fraud conducted by another brokerage house chief seems dangerously incongruent.

In conclusion, the Article posits that future SEC rulemaking should remove all uncertainty surrounding the application of Rule 10b-5 to Ponzi schemes driven by the promoter’s reputation. In turn, such certainty (along with reforms to the investment advisory custodial process) should solidify both expectations and remedies when there is a lack of actual investment. In short, with some tweaking, the rules can better support the decision to reimburse those unfortunate investors who entrust funds with industry “players” who are later revealed to be to be merely market mascots.

September 2, 2012 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)