Securities Law Prof Blog

FINRA Charges David Lerner with Suitability Obligations in Marketing REITs

FINRA announced today that it filed a complaint against David Lerner & Associates, Inc. (DLA), of Syosset, NY, charging the firm with soliciting investors to purchase shares in Apple REIT Ten, a non-traded $2 billion Real Estate Investment Trust (REIT), without conducting a reasonable investigation to determine whether it was suitable for investors, and with providing misleading information on its website regarding Apple REIT Ten distributions. DLA has sold and continues to sell Apple REIT Ten targeting unsophisticated and elderly customers with unsuitable sales of the illiquid security.

Since January 2011, as sole underwriter for Apple REIT Ten, DLA has sold over $300 million of an open $2 billion offering of the REIT's shares. Apple REIT Ten invests in the same extended stay hotel properties as a series of other Apple REITs closed to investors. Apple REIT Ten and the closed Apple REITs were founded by the same individual, and are all under common management. DLA has been the sole underwriter for Apple REITs since 1992, selling nearly $6.8 billion of the securities into approximately 122,600 DLA customer accounts. DLA earns 10 percent of all offerings of Apple REIT securities as well as other fees. Apple REIT sales have generated $600 million for DLA, accounting for 60 to 70 percent of DLA's business annually since 1996.

The complaint against DLA alleges that since at least 2004, the closed Apple REITs have unreasonably valued their shares at a constant price of $11 notwithstanding market fluctuations, performance declines and increased leverage, while maintaining outsized distributions of 7 to 8 percent by leveraging the REITs through borrowings and returning capital to investors. As sole distributor, DLA did not question the Apple REITs' unchanging valuations despite the economic downturn for commercial real estate.

FINRA alleges that DLA failed to sufficiently investigate the valuation and distribution irregularities of the closed Apple REITs prior to selling Apple REIT Ten. As the sole underwriter of all of the Apple REITs, DLA was aware of the Apple REITs' valuation and distribution practices. Rather than conduct due diligence into those valuations and distribution irregularities to determine that they were reasonable and that the Apple REITs were suitable, DLA accepted the valuations and continued to record them on customer account statements.

In its solicitation of customers to purchase Apple REIT Ten, DLA's website provided distribution rates for all of the previous Apple REITs. These distribution figures were misleading and omitted material information because they did not disclose recent distribution rate reductions or that distributions far exceeded income from operations and were funded by debt that further leveraged the REITs.

The issuance of a disciplinary complaint represents the initiation of a formal proceeding by FINRA in which findings as to the allegations in the complaint have not been made, and does not represent a decision as to any of the allegations contained in the complaint.

Schwarcz on Securitization Markets

Testimony on the State of the Securitization Markets, by Steven L. Schwarcz, Duke University - School of Law, was recently posted on SSRN.  Here is the abtract:

In this May 18, 2011 testimony before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, I suggest certain regulatory responses to improve securitization. Certain of securitization’s problems are typical of problems we must face in any innovative financial market: that increasing complexity, coupled with human complacency (among other factors), will make failures virtually inevitable. Regulation must respond to this reality by putting into place, before these failures occur, responses that supplement regulatory restrictions intended to prevent failures.

Molony on Security-Based Swaps

Still Floating: Security-Based Swap Agreements after Dodd-Frank, by Thomas Molony, Elon University School of Law, was recently posted on SSRN.  Here is the abstract:

The Commodity Futures Modernization Act of 2000 (the "CFMA") established that most swaps were not securities for purposes of the Securities Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act"). At the same time, however, the CFMA subjected certain swaps - security-based swap agreements - to the antifraud prohibitions under Securities Act § 17(a) and Exchange Act § 10(b) and Rule 10b-5. Since the CFMA was enacted, few courts have interpreted the term "security-based swap agreement" and only one has given it significant substantive attention.

Congress’s enactment of The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") in 2010 changed the playing field for swaps dramatically, subjecting them to extensive regulation by the Securities Exchange Commission (the "SEC") and the Commodity Futures Trading Commission. The regulations with respect to security-based swap agreements survived the reform, but their continuing utility in the new regulatory regime is an open question.

This Article examines the historical interpretation of the term "security-based swap agreement," its application in pending SEC enforcement actions involving interest rate swaps and the continuing viability post-Dodd-Frank of the provisions of the Securities Act and the Exchange Act applicable to security-based swap agreements. The Article begins with a discussion of how the securities laws applied to swaps prior to Dodd-Frank. After reviewing and critiquing the handful of opinions that have considered the scope of the term "security-based swap agreement," it considers whether the interest rate swaps at issue in the pending SEC enforcement actions are security-based swap agreements. The Article next describes generally the jurisdictional division between the SEC and the CFTC under Dodd-Frank and how security-based swap agreements fit within the new regime. It then explores reasons to do away with the security-based swap agreement in the federal securities laws, while considering whether term represents a necessary evil. The Article ultimately concludes that Congress should eliminate the provisions of the Securities Act and the Exchange Act related to security-based swap agreements because (i) the provisions largely have gone unused, (ii) the term "security-based swap agreement" has been poorly interpreted, (iii) the term is overbroad, (iv) Dodd-Frank makes the provisions unnecessary and (v) the term creates unnecessary confusion in the new regulatory scheme.

Former Nvidia Analyst Pleads Guilty in Expert-Networks Insider Trading Investigation

The feds have another notch on its belt in its ongoing investigation of insider-trading at expert-networks firms.   Sonny Nguyen, a former Nvidia financial analyst, pleaded guilty today to providing tips on the firm's earnings between 2007-08 to Winifred Jiau, a former consultant with Primary Global Resources, in exchange for other stock tips.  Ms. Jiau's trial is scheduled to begin soon, and he is expected to testify as a government witness.

In addition, another individual, Sam Barai, a former hedge fund manager, is expected to plead guilty this afternoon.

WSJ, Ex-Nvidia Analyst Pleads Guilty in Insider Trading Case

Former NASDAQ Managing Director Charged with Insider Trading

The SEC today charged Donald L. Johnson, a former managing director of The NASDAQ Stock Market, with multiple instances of insider trading.  According to the SEC’s complaint, Johnson held various positions at the NASD and NASDAQ for 20 years, until his retirement from NASDAQ in September 2009. From at least January 2000 to October 2006, Johnson worked in NASDAQ’s Corporate Client Group (CCG). He then transferred to the Market Intelligence Desk, a specialized department within the CCG that provides issuers with general market updates, overviews of their company’s sector, and commentary regarding the factors influencing day-to-day trading activity in their stocks.

The SEC alleges that, through his positions in the CCG and Market Intelligence Desk, Johnson had frequent and significant interactions with senior executives of NASDAQ-listed issuers, including CEOs, CFOs, and investor relations officers at his assigned companies. In those interactions, company executives routinely shared confidential information with Johnson regarding impending public announcements that could affect the price of their stocks.

According to the SEC’s complaint, Johnson unlawfully traded in advance of nine announcements of material nonpublic information involving NASDAQ-listed companies from August 2006 to July 2009. Johnson took advantage of both favorable and unfavorable information that was entrusted to him in confidence by NASDAQ and its listed companies, shorting stocks on several occasions and establishing long positions in other instances. The complaint also states that Johnson often placed the trades directly from his work computer through an online brokerage account in his wife’s name. The SEC alleges that Johnson reaped illicit profits in excess of $755,000 from his illegal trading.

Johnson also has been charged in a parallel criminal action announced by the U.S. Department of Justice today.

Banks Sue Brokers Over Med Cap Fraud

Bank of New York Mellon Corp. and Wells Fargo Bank, who were trustees for Medical Capital Holdings, have sued a number of broker-dealers that marketed the Med Cap private placement offerings, claiming that the broker-dealers sold the securities to investors for whom it was an unsuitable investment and made misrepresentations about the investment's risks.  The banks are defendants in a 2009 class action that followed SEC charges that Med Cap was a fraud.  InvNews, Wells Fargo, BoNY Mellon sue Securities America, other B-Ds over MedCap

FINRA Fines Credit Suisse & Merrill Lynch for Misreps Involving Subprime Mortgage Securitizations

FINRA announced today that it fined Credit Suisse Securities (USA) LLC $4.5 million, and Merrill Lynch $3 million for misrepresenting delinquency data and inadequate supervision in connection with the issuance of residential subprime mortgage securitizations (RMBS).

Issuers of subprime RMBS are required to disclose historical performance information for past securitizations that contain mortgage loans similar to those in the RMBS being offered to investors. Historical delinquency rates are material to investors in assessing the value of RMBS and in determining whether future returns may be disrupted by mortgage holders' failures to make loan payments. As there are different standards for calculating delinquencies, issuers are required to disclose the specific method it used to calculate delinquencies. 

FINRA found that in 2006, Credit Suisse misrepresented the historical delinquency rates for 21 subprime RMBS it underwrote and sold. Although Credit Suisse knew of these inaccuracies, it did not sufficiently investigate the delinquency errors, inform clients who invested in these securitizations of the specific reporting discrepancies or correct the information on the website where the information was displayed. Credit Suisse also failed to name or define the methodology used to calculate mortgage delinquencies in five other subprime securitizations. Additionally, Credit Suisse failed to establish an adequate system to supervise the maintenance and updating of relevant disclosure on its website. 

For six of the 21 securitizations, the delinquency errors were significant enough to affect an investor's assessment of subsequent securitizations, as it was referenced in four subsequent RMBS investments. 

In a separate case, FINRA found that Merrill Lynch negligently misrepresented the historical delinquency rates for 61 subprime RMBS it underwrote and sold. However, in June 2007, after learning of the delinquency errors, Merrill Lynch promptly recalculated the information and posted the corrected historical delinquency rates on its website. Merrill Lynch also failed to establish a reasonable system to supervise and review its reporting of historical delinquency information. On January 1, 2009, Merrill Lynch was acquired by Bank of America, but the firm continues to do brokerage business under its own individual broker-dealer registration. 

In eight instances, the delinquencies were significant enough to affect an investor's assessment of subsequent securitizations, as it was referenced in five subsequent RMBS investments.

SEC Proposes Rule Disqualifying "Bad Actors" from Reg D Offerings

The SEC today proposed a rule to deny certain securities offerings from qualifying for exemption from registration if they involve certain “felons and other bad actors.”  The proposed rule would implement a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Regulation D provides three exemptions that a company can use to avoid registration under the securities laws, the most widely used of which is Rule 506. If an offering qualifies for the Rule 506 exemption, an issuer can raise unlimited capital from an unlimited number of accredited investors and up to 35 non-accredited investors.  Under the proposed rule, an offering would be unable to rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “disqualifying event” such as a criminal conviction, court injunction and restraining order.

SEC Adopts Final Whistleblower Rules

The SEC today adopted rules to create a whistleblower program that rewards individuals who provide the agency with high-quality tips that lead to successful enforcement actions.  The new SEC whistleblower program, implemented under Section 922 of the Dodd-Frank Act, is primarily intended to reward individuals who act early to expose violations and who provide significant evidence that helps the SEC bring successful cases.  To be considered for an award, the SEC’s rules require that a whistleblower must voluntarily provide the SEC with original information that leads to the successful enforcement by the SEC of a federal court or administrative action in which the SEC obtains monetary sanctions totaling more than $1 million.

The SEC’s rules will be effective 60 days after they are submitted to Congress or published in the Federal Register.

SEC Signs Lease for Unnecessary Space, Backdates Documentation

Once again the SEC is caught in an embarrassing incident involving its leasing of space.  In addition, the SEC Inspector General's Report on its investigation of this episode found that SEC personnel backdated forms to cover up unauthorized actions.  According to the executive summary:

The OIG investigation found that the circumstances surrounding the SEC's entering into a lease contract with David Nassif Associates ("DNA") for 900,000 square feet of space at the Constitution Center facility in July 2010 represents another in a long history ofmissteps and misguided leasing decisions made by the SEC since it was granted independent leasing authority by Congress in 1990....

The OIG investigation further found that based upon estimates ofincreased funding primarily to meet the requirements ofthe Dodd-Frank: Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), between June and July of2010, the SEC Office ofAdministrative Services ("OAS") conducted a deeply flawed and unsound analysis to justify the need for the SEC to lease 900,000 square feet of space at the Constitution Center facility. We found that OAS grossly overestimated the amount of space needed at SEC Headquarters for the SEC's projected expansion by more than 300 percent and used these groundless and unsupportable figures to justify the SEC committing to an expenditure of $556,811 ,589 over 10 years.

The OIG investigation also found that OAS prepared a faulty Justification and Approval to support entering into the lease contract for the Constitution Center facility without competition. This Justification and Approval was prepared after the SEC had already signed the contract to lease the Constitution Center facility. Further, OAS backdated the Justification and Approval, thereby creating the false impression that it had been prepared only a few days after they entered into the lease contract. In actuality, the Justification and Approval was not finalized until a month later.

See REPORT OF INVESTIGATION UNITED STATES SECURITIES AND EXCHANGE COMMISSION OFFICE OF INSPECTOR GENERAL, Case No. OIG-553, Improper Actions Relating to the Leasing of Office Space

ProPublica's Cheat Sheet on Bank Investigations

ProPublica's Marian Wang has posted a Cheat Sheet on Bank Investigations and the Probes That Have Petered Out.  It's well worth checking out.

Chrysler Repays Outstanding TARP loans

Today, the U.S. Department of the Treasury announced that Chrysler Group LLC has repaid its outstanding Troubled Asset Relief Program (TARP) loans. Chrysler Group LLC repaid $5.1 billion in TARP loans and terminated its ability to draw a remaining $2.1 billion TARP loan commitment. Treasury committed a total of $12.5 billion to Chrysler under TARP’s Automotive Industry Financing Program (AIFP). With today’s transaction, Chrysler has returned more than $10.6 billion of that amount through principal repayments, interest, and cancelled commitments.  Treasury continues to hold a 6.6 percent common equity stake in Chrysler. Treasury is unlikely to fully recover its remaining outstanding investment of $1.9 billion in Chrysler.

FINRA's Ketchum Addresses Compliance, Fiduciary Standard and other Challenges at Conference

Richard G. Ketchum, Chairman and Chief Executive Officer, FINRA, spoke today at the FINRA Annual Conference in Washington, DC.  In his prepared remarks, Mr. Ketchum "shared ... some of what we're focused on right now at FINRA, including changes to our exam program. I'd also like to offer some observations about what we're seeing from the industry, both in terms of improved compliance and challenges facing firms, as well as areas that I think we both should be thinking about as the industry looks toward a fiduciary standard."

Carpenters Union Petitions SEC for Rulemaking to Eliminate "Withhold Authority" Vote

The United Brotherhood of Carpenters and Joiners of America filed a petition with the SEC to initiate a rulemaking to amend Rule 14a-4(b)(2)3 (Requirements as to proxy) to eliminate the "withhold authority" vote on proxy forms used for the election of corporate directors.  According to the petition,

the "withhold authority" vote," or so-called "withhold" vote, established decades ago to "provide greater opportunities for shareholders to exercise their right of suffrage ... ," has outlived its intended purpose. The widespread adoption of a majority vote standard in director elections provides shareholders a valid opposition vote ("against") that has a "legal effect" in determining whether a nominee is elected. The symbolic "withhold" vote, a vestige of a plurality vote standard era, is not a valid vote option under any vote standard and its continued use contributes to confusing and misleading proxy communications that threaten the integrity of director elections.

Massachusetts & Securities America Settle Medical Capital Notes Private Placement Allegations

The Massachusetts Securities Division announced today that Securities America Agrees to Make Investors Whole In Settlement of Medical Capital Notes Private Placement Securities Case (May 23, 2011).

FINRA & Nuveen Settle ARS Disclosure Allegations for $3 Million

FINRA announced today that it fined Nuveen Investments, LLC, of Chicago, $3 million for creating misleading marketing materials used in sales of auction rate preferred securities (ARPS).  In contrast to other types of auction rate securities, the Nuveen ARPS were preferred shares issued by closed end mutual funds to raise money for the funds to use to invest.

By early 2008, over $15 billion of Nuveen Funds' ARPS had been sold to retail customers by third-party broker-dealers. Nuveen did not sell the ARPS to customers, but in its role as distributor for Nuveen Funds, it created marketing brochures that were used by the broker-dealers who sold the ARPS to retail customers. The brochures were the primary sales and marketing material Nuveen created for the auction rate preferred securities. FINRA found that the brochures, also available on Nuveen's website, failed to adequately disclose liquidity risks for ARPS. Nuveen neglected to include the risks that auctions for the ARPS could fail, investments could become illiquid and that customers might be unable to obtain access to funds invested in the ARPS for a period of time should the auctions fail. Instead, the brochures contained misleading statements which described the ARPS as safe and liquid investments. Also, FINRA found that Nuveen failed to maintain adequate supervisory procedures to ensure that the materials it used to market the auction rate preferred securities accurately described the features and risks of the securities.

Nuveen failed to revise disclosures in their brochures after a lead auction manager responsible for approximately $2.5 billion of the ARPS notified Nuveen in early January 2008 that it intended to stop managing Nuveen auctions. On January 22, 2008, the lead manager did not submit support bids in an auction for a series of Nuveen auction rate preferred stock and that auction failed. FINRA found that the auction failure and Nuveen's inability to find a replacement for the lead manager raised serious questions for Nuveen about whether investors in Nuveen's ARPS would be able to obtain liquidity for the securities in future auctions. Despite this, Nuveen failed to revise its marketing brochures to reflect these risks and, thus, the brochures were misleading. In February 2008, widespread auction failures occurred throughout the auction rate securities market, including auctions for Nuveen funds ARPS.

To date, the Nuveen funds have redeemed approximately $14.2 billion of the $15.4 billion of the ARPS that were outstanding on February 12, 2008. As part of the settlement, Nuveen agreed to use its best efforts to effect redemptions of any remaining outstanding Nuveen funds ARPS.

 

Fried on Executive Pay

Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay, by Jesse M. Fried, Harvard Law School, was recently posted on SSRN.  Here is the abstract:

This Article identifies a cost to public investors of tying executive pay to the future value of a firm’s stock - even its long-term value. In particular, such an arrangement can incentivize executives to engage in share repurchases (when the current stock price is low) and equity issuances (when the current stock price is high) that reduce “aggregate shareholder value,” the amount of value flowing to all the firm’s shareholders over time. The Article also puts forward a mechanism that ties executive pay to aggregate shareholder value and thereby eliminates the identified distortions.

SEC Looking for CPA for PCAOB Board

Do you know someone who is well-qualified to serve on the Public Company Accounting Oversight Board?  The SEC is seeking suggestions.  Sarbanes-Oxley requires that Board members be “appointed from among prominent individuals of integrity and reputation who have a demonstrated commitment to the interests of investors and the public, and an understanding of the responsibilities for and nature of the financial disclosures required of issuers under the securities laws and the obligations of accountants with respect to the preparation and issuance of audit reports with respect to such disclosures.” Currently, the Commission is seeking a candidate for the Board who is, or has been, a Certified Public Accountant (CPA).

At its website the SEC has posted sample letters that have been sent to seek input that describe the minimum qualifications in greater depth.  Names and qualifications should be submitted for consideration by June 17.

Agenda for SEC's May 25 Meeting

The agenda for the SEC's next Open Meeting on May 25, 2011:

1. The Commission will consider whether to propose amendments to Regulation D under the Securities Act of 1933 to disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on the Rule 506 safe harbor exemption from Securities Act registration. These proposals are designed to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
2. The Commission will consider whether to adopt rules and forms to implement Section 21F of the Securities Exchange Act of 1934 entitled “Securities Whistleblower Incentives and Protection.” Section 21F, as added by Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, provides that the Commission shall pay awards, under regulations prescribed by the Commission and subject to certain limitations, to eligible whistleblowers who voluntarily provide the Commission with original information about a violation of the federal securities laws that leads to the successful enforcement of a covered judicial or administrative action, or a related action

Caveat Emptor Prevails in Georgia

I blogged yesterday afternoon about the Investment News report on Brown v. J.P. Turner & Co. (N.D. Ga. May 17,2011)( Download J P TURNER) in which the federal district court dismissed all claims brought by investors in Provident Royalties LLC against the broker-dealer that marketed the securities to them through purported "private placement" offerings.  Provident went bankrupt, the SEC filed suit for fraud and obtained a freeze on Provident's assets.  I have now read the opinion and can report that it is every bit as bad as I feared.

Plaintiffs filed the class action and alleged that defendants (1) failed to comply with the notice and registration requirements of the Georgia Securities Act (GSA); (2) committed fraud in violation of the GSA; (3) committed common law negligence and (4) made negligent misrepresentations.   The court dismissed all counts for failure to plead fraud with the requisite specificity.  More disturbingly, it also, with respect to counts (3) and (4), dismissed for failure to state a claim, because the court agreed with defendant that the negligence claims were deficient because defendant did not have a duty to discover or disclose Provident's fraud.

It's hard to know how much of this horrendous opinion is attributable to strategic errors on the part of plaintiffs' attorneys and how much to judicial hostility.  Much of the opinion is devoted to the court's addressing the inadequacies of the pleading, especially pleading "on information and belief," and the plaintiffs' failure to plead with the requisite specificity a misstatement/omission of material fact and scienter.  Plaintiffs' negligence counts were also, according to the court, "essentially generic recitations of the elements of each claim" and therefore did not meet the pleading requirements.  Plaintiff also, at least according to the court, did not argue that the firm acted as an underwriter, but conceded it was the broker. 

The result, however, is a decision where the federal district court, as an alternative ground for granting the MTD, finds that the complaint did not state negligence claims under Rule 12(b)(6), because the plaintiff did not show that the defendant owed them a legal duty.  Specifically,

"Plaintiffs did not allege any facts, or cite any Georgia authority, to support their conclusionary statement that defendant owed a duty to confirm the accuracy of Provident's statements in the PPMs.  Neither has the Court found any Georgia authority that imposes a duty on a broker to conduct due diligence concerning the investment materials it provides to clients."

Remember that J.P. Turner was marketing these securities.  What about the duty of a broker-dealer to "know the security" it is marketing to investors?  What about the duty to have a "reasonable basis" for recommending a security?  J.P. Turner was not filling unsolicited orders here.  Do the FINRA rules have no applicability in the great state of Georgia?

As if the above weren't bad enough, the court goes on to state that plaintiffs did not allege any reliance on defendant's efforts and that even if they had, the reliance would be unreasonable, "as the PPMs expressly advise potential investors that they should only rely on information provided by Provident itself."  What's the point of a broker-dealer's recommendation if the investors have to read the PPMs themselves.

Caveat emptor, all you investors in Georgia!