Monday, October 28, 2013

SEC Finally Issues 568-Page Regulation Crowd funding Proposal

Small start-up companies that applauded the 2012 Jump Start Our Business Start-ups Act have 90 days to respond to the SEC's October 23, 2013 proposal. The single-spaced Table of Contents for the proposal exceeds 2 pages. The goal of the Act the SEC seeks to implement was intended to help small issuers reach numerous small investors via the internet. Yet the proposal contains hundreds of pages of “restrictions,” “limitations,” and requirements. 

The media was all a-buzz last week about the long awaited proposal. In all fairness, the SEC was put in a bit of a bind by the JOBS Act's crowd funding provisions. How does one fashion a new system that keeps the fraudulent wolf at bay while simultaneously making it much easier for less sophisticated sheep to answer his knock at the door? The SEC's primary suggested method is an online portal coupled with the Act's explicit investment caps.

The proposal's introductory comments (pp. 6-11) provide an excellent succinct overview. After that—you are on your own until we at Cosgrove Law Group have a chance to work through it ourselves. And if you are really too busy at the moment, the Wall Street Journal and the Washington Post boil the entire matter down to a couple of dozen paragraphs.   

Thursday, October 17, 2013

D.C. Circuit Court of Appeals Considers Whether Stanford Fraud Victims are “Customers” under the Securities Investor Protection Act

Despite the famous R. Allen Stanford Ponzi scheme being unraveled in early 2009, the past two weeks have been important for the victims of the fraud who are still trying to recover their financial losses.  On October 7, the Supreme Court heard arguments on whether the Securities Litigation Uniform Standards Act precludes investors from bringing state law claims against third-party entities who allegedly participated in Stanford’s fraudulent scheme.  For further discussion on that topic, click here

Yesterday, the SEC argued in front of the D.C. Circuit Court of Appeals seeking to overturn a District Court’s ruling that barred the agency from ordering the Securities Investor Protection Corp. (“SIPC”) to compensate victims of the Stanford Ponzi scheme.  SIPC is a congressionally chartered corporation that oversees liquidation of failed brokerages and may also pay investors’ claims for missing money or securities through an industry-financed fund.    

Since the CD’s at the heart of the Ponzi scheme were marketed to investors by Houston-based Stanford Group Company (“SGC”) – a broker dealer registered with the SEC and SIPC – in 2009, the court appointed receiver of Stanford’s companies asked SIPC to evaluate whether the customers of SGC were entitled to SIPC’s protection.  SIPC declined to file an application for protective decree because it concluded that SGC did not perform a custody function for the customers who purchased CD’s from the Antigua-based Stanford International Bank (“SIB”) which was not a member of SIPC.  However, in 2011, the SEC issued a formal analysis disagreeing with SIPC’s position and filed an application in District Court ordering SIPC to meet its obligations. 

This is the first time the SEC has requested a court to force SIPC to extend its coverage.  During the proceedings in the District Court, the key issue was whether persons who purchased CD’s from SIB were considered customers of SGC within the meaning of the Securities Investor Protection Act.  SIPA defines “customer” as follows:

The term ‘customer’ of a debtor means any person (including any person with whom the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer.
The term `customer' includes—
(i) any person who has deposited cash with the debtor for the purpose of purchasing securities;…

SIPCs argued that although many of the victims purchased the foreign CD’s through SGC, the victims ultimately entrusted their money with SIB which was not a member of SIPC.  Furthermore, investors received disclosures explicitly telling them the Antiguan bank was not SIPC-protected or regulated by the U.S. 

The SEC, however, argued that the location of the Stanford bank is irrelevant because Stanford’s entire business organization was operating one massive fraud, and that no actual certificates of deposit truly existed.

The District Court found that since SGC never physically possessed the investors’ funds at the time of the purchases, the investors were not customers of SGC under the literal construction of the statute.  Click here to review the court’s opinion.   

During oral arguments in front of the D.C. Circuit, much of the hearing was consumed by discussion and debate over the legal definition of “customer” and whether the SEC can force SIPC to construe that term to include victims of a collapse that involves both member and non-member companies.  Just like the highest court last week, the Circuit judges gave no clear indication of how they will rule. 

A few former SEC commissioners filed a friend of the court brief urging the Circuit to uphold the lower court’s ruling because an “unwarranted expansion” of the term “customer” has the potential to substantially increase SIPC’s exposure and could threaten its ability to function as Congress intended.

In sum, the rulings of the Supreme Court and the D.C. Circuit Court of Appeals will both have a substantial impact on the victims’ chances to recover their losses.  

Wednesday, October 16, 2013

U.S. Supreme Court Debates Coverage of the Securities Litigation Uniform Standards Act

The U.S. Supreme Court recently debated whether investors in a consolidated class action suit were precluded by the Securities Litigation Uniform Standards Act (“SLUSA”) from bringing state law causes of action against law firms and other third party entities for their alleged roles in the $7 billion R. Allen Stanford Ponzi scheme. SLUSA bars plaintiffs from bringing state law claims based on misrepresentations made “in connection with the purchase or sale of a covered security.” 

The Ponzi scheme at the center of the allegations involved over 21,000 investors who bought certificates of deposit from R. Allen Stanford’s bank in Antigua. Stanford promised a risk-free investment with above-market rates of return and said the CDs were backed by portfolios of liquid securities.  However, there were no securities and the money went to fund a string of failed businesses, bribe regulators, and support Stanford’s lavish lifestyle. R. Allen Stanford was convicted and sentenced to 110 years in prison in March of 2012.  The receiver, who was court appointed in 2009 to recover money from Stanford’s failed companies to return to investors, recently began mailing checks ranging from $2.81 to $110,000 to hundreds of investors.  That amounts to approximately $55 million of the $6 billion lost from the scheme – less than a penny on the dollar.

The complaints filed by investors alleged that various third party entities made misrepresentations concerning the safety of the investments and that Stanford’s attorneys conspired with and aided and abetted Stanford in violating the securities laws by lying to the SEC and assisting Stanford to evade regulatory oversight.

The District Court examined whether a covered security was applicable in the case because although the CD was not a covered security, the marketable securities purportedly backing the CD’s were a covered security.  During this analysis, the District Court used the Eleventh Circuit’s approach, which asks “whether a group of plaintiffs premise their claim on either ‘fraud that induced [the plaintiffs] to invest with [the defendants] … or a fraudulent scheme that coincided and depended upon the purchase or sale of securities.’” The District Court determined that the belief that the CD’s were backed by marketable securities induced the investors to purchase the CD’s.  Therefore, the District Court dismissed the investors’ claims.

On appeal, the Fifth Circuit reversed the decision, rejecting the test applied in the Eleventh Circuit and adopted the Ninth Circuit test: “A misrepresentation is ‘in connection with’ the purchase or sale of a security if there is a relationship in which the fraud and the stock sale coincide or are more than tangentially related.”  The Fifth Circuit relied on public policy considerations that requires interpretation of the “in connection with” element in a manner not to preclude group claims simply because the issuer advertises that it owns covered securities in its portfolio. 

In order to resolve the circuit split on the interpretation of SLUSA’s “in connection with” requirement, the Supreme Court granted certiorari. The issues considered by the highest court were the following: (1) whether the Securities Litigation Uniform Standards Act (SLUSA) precludes a state-law class action alleging a scheme of fraud that involves misrepresentations about transactions in SLUSA-covered securities; and (2) whether SLUSA precludes class actions asserting that defendants aided and abetted SLUSA-covered securities fraud when the defendants themselves did not make misrepresentations about the purchase or sale of SLUSA-covered securities.

Plaintiffs hinge part of their argument on the fact certificates of deposits were specifically excluded from Congress’s definition of “covered security” and request the Court uphold the 5th Circuit’s ruling.  The defendants claimed that the application of federal law should be broad and because Stanford made the promise to back the CD’s with securities, the SLUSA effectively blocks the state causes of action.

During oral arguments, the nine justices gave no clear indication on how they will rule.  However, Justice Scalia’s questions and comments suggested he felt the suits could go forward because he read the statutory language “in connection with the purchase or sale of a covered security.”  Justice Alito, on the other hand, read “in connection with” broadly.  Stay tuned for and update when the court releases its ruling.   

Tuesday, October 15, 2013

FINRA Releases Comprehensive Report on Conflicts of Interest

Last month FINRA issued a 44-page report on conflicts of interest within the financial services industry. The report focuses specifically on the conflict management practices of broker-dealer firms. During my experience representing both investors and FINRA members, or while serving as an expert witness, I have frequently identified a conflict of interest to as genesis of the legal claim. FINRA's report is an outstanding review of both the source of troublesome conflicts and current best practices within the industry.

FINRA's report does not pull any punches. It comes out of the gate with the following observation: “Conflicts of interest can arise in any relationship where a duty of care or trust exists between two or more parties, and as a result, are widespread across the financial service industry...[M]any broker-dealer firms have made progress in improving their conflicts management practices, but...firms should do more to manage and mitigate conflicts of interest in their businesses.” (report link)

The report is broken out in to a review of “three critical areas.” FINRA evaluates and discusses: 1) firm-level frameworks, 2) new financial products, and 3) registered rep. compensation. FINRA defines firm-level frameworks as “the combination of underlying ethics culture, organizational structures, policies, processes, and incentive structures.” I found the report's second section regarding the introduction and promotion of new financial products to be worthy of a “must read” classification for both the compliance and the executive sales side of any firm. The final section of the report lays out what FINRA believes to be six “effective practices” for mitigating conflicts of interest generated by rep. compensation arrangements.

Now that FINRA has spoken in great detail on the matter, firms should be very hesitant about going forward without implementing the practices suggested in the report. While FINRA specifically disavows the report as rule-making, firms will be caught flat-footed if they face an investor claim or regulatory action rooted in the absence of the suggested best practices.