Mississippi Supreme Court Prohibits Sanctions for Each Affected Investor

Last month the Supreme Court of Mississippi handed down its 6-3 split opinion in the matter of Harrington v. Mississippi Secretary of State. The appellants in this case were officers in a real estate investment company. The officers solicited and sold over $1,500,000 of membership interests in the investment company through a private placement memorandum (PPM). The solicitation projected $60,000,000 in revenue and $20,000,000 in earnings over five years. Finally, the PPM provided that full and complete “records and books of accounts would be maintained and available to the investors.”

The Secretary of State's Securities and Charities Division ultimately issued a summary Cease and Desist Order against the company—SteadiVest, LLC. Among other things, the Division alleged that StediVest was a Ponzi scheme and that the PPM misled investors. The Division charged the two officers with five violations of the Mississippi Securities Act.

An administrative hearing was held on the allegations after which the hearing officer recommended that a penalty of $1,585,000 be imposed—the amount raised by the offering. Regardless, the Secretary of State issued a Final Order fining one officer $850,000 and the other $170,000. The officers appealed to the court system. The lower court upheld the Secretary of State's Order, and the officers appealed once again.

The Supreme Court dispensed with ease the officers' challenge to the sufficiency of the evidence against them. It also rejected their claims that the warnings in the PPM were sufficient and that the Division should have been required to prove scienter (knowing or intentional conduct). The Court's scienter analysis was grounded in the parallel between the Model Securities Act and Section 17 of the Federal Securities Act of 1933, as well as the variant scienter requirements within 17(a)(b) and (c). Perhaps more on this aspect of the opinion in a future blog.

This blog is intended to draw the reader's attention to one specific portion of the Supreme Court's analysis that deals with the calculation of fines for the two officers. Why is this important? In my experience, regulators frequently seek to ratchet up the total potential statutory fine by dissecting a single violation into a multitude of violations in order to achieve a drastic multiplier of the statutory fine exposure.

The Supreme Court's analysis in this regard can be found on pp.18-19 of the opinion. The Supreme Court upheld the Secretary of State's determination that two separate violations occurred, segregating the PPM violation from the books and records violation, but it rejected the Secretary of State's subsequent application of a multiplier of 17 for each affected investor.

Finally, anyone who has defended an agent or investment adviser representative before a state securities regulator might take some comfort in the Presiding Justice's dissenting opinion in this case. To give you just a taste:

If the majority intends to say that the Legislature has given the Secretary of State the power and authority to find a violation for ever representation in a securities offering that the Secretary of State subjectively believes might (as opposed to did or, unless abated, is going to) operate as a fraud, then it is enough for me to say that I simply reject that tortured interpretation of the statute. In my view, some proof is required that someone actually did detrimentally rely, or actually would have detrimentally relied, on the representations.

And:

The word fraud is understood by nearly everyone who can spell it (including my esteemed colleagues in the majority), to mean an intentional material, less than truthful, representation upon which the speaker intends the victim to rely, and upon which the victim does actually, detrimentally, rely¹. This Court has applied that meaning since before Mississippi became a state, and the English were employing it in the Common Law when Henry VIII schemed a way to marry Anne Boleyn. Law students must know and apply that meaning on law school and bar exams.

Food for thought.

________________________________________________________

1Hobbs Auto, Inc. v. Dorsey, 914 So.2d 148, 153 (Miss.2005)

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 5^th 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.   

Has the SEC Stepped Up to the Plate on Fraud Enforcement Actions?

The Securities and Exchange Commission’s (“SEC”) mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  The SEC believes that its “investor protection mission is more compelling than ever” since more first-time investors have turned to the market to invest in their future.  Therefore, it goes without saying that the SEC’s enforcement authority is crucial in maintaining investor protection.  But, has the SEC stepped up to the plate considering the negative impact the 2008 financial crisis has had on investors?

The 2008 financial crisis had devastating effects on our economy which caused massive job losses and a growing number of American families at risk of foreclosure and poverty.  However, some companies made substantial profits from the financial collapse and many top executives received considerable bonuses (some from government bailout money) after millions of families’ investments dwindled or even disappeared. 
Most recently, the SEC filed civil fraud charges in Texas against former Chief Executive Anthony Nocella and former Chief Financial Officer J. Russell McCann of Franklin Bank Corp. for concealing the deterioration of the bank’s finances during the mortgage crisis.  Specifically, the SEC alleged that in 2007, Nocella and Man used aggressive loan modification programs to hide the bank’s non-performing loans and artificially boost profits.  See SEC Complaint. 

Despite having charged over 100 people and firms with fraud tied to the financial crisis, critics of the SEC believe the agency hasn’t buckled down hard enough.  Yet SEC enforcement chief, Robert Khuzami, believe these numbers show the agencies effectiveness in “tackling financial-crisis wrong-doing.”  Of the 74 cases filed against individuals, 55 are chief executives, finance chiefs or other top officers.  Khuzami believes this “sends a strong deterrent message.”  

Many of the SEC critics note that about 24 of the people charged by the SEC have avoided trial by reaching “weak” settlements.  Senator Grassley from Iowa stated, “The lack of accountability from Wall Street encourages recidivism.” 

For instance, Angelo Mozilo, Chief Executive of Countrywide Financial Corp., agreed to a settlement of $67.5 million ($22.5 million penalty and $45 million disgorgement), while denying any wrongdoing.  These sanctions are supposed to compensate investors for their losses.   However, the repayment of illegal profits is tax-deductible and can be covered by some corporate insurance policies.  In Mozilo’s case, nearly half of the $45 million payment came from Countrywide's current owner, Bank of America Corp.  It can be difficult for the SEC to challenge indemnification rights in employment contracts or insurance policies.

According to The Wall Street Journal, in the 24 crisis-related cases where the SEC reached a settlement with an individual, the median sanction was $203,751.  These same defendants paid a combined $80.7 million in penalties.  Most of those penalties came from executives at collapsed mortgage lenders such Countrywide, American Home Mortgage Investment Corp. and New Century Financial Corp.; yet, their investors sustained losses of about $31 billion based on the three companies' peak stock-market value before the financial crisis began.  These penalties arguably pale in comparison to investor losses. 
Even some federal judges have criticized the large gaps between investor losses and the penalty.  For example, U.S. District Judge Frederic Block in New York, said $1.05 million in penalties paid by two former Bear Stearns Cos. hedge-fund managers, Ralph Cioffi and Matthew Tannin, in a proposed settlement of civil-fraud charges against them was “chump change” compared with the $1.8 billion lost by investors. The judge has not yet approved the proposed settlement.

While to some, the above penalties may seem like an inadequate punishment for the charges, Cioffi and Tannin have agreed to a temporary ban from the securities industry.  Khuzami believes the SEC’s power to expel people from the securities industry or from serving as directors of public companies is “probably one of the most powerful sanctions [it has].” 

Furthermore, when reaching settlements, the SEC has to weigh the likelihood of losing to a jury, along with the amount the agency can show was a direct result of the wrongdoing.  In some cases, it can be hard to say with certainty how much of investor losses were caused by fraud or illegal conduct, or if any fraud or illegal conduct actually took place.  Usually, defendants argue the financial losses were due to a failure to predict the meltdown, rather than any fraud on their part.  The answer is not always clear cut and pushing for stricter penalties across the board may not be appropriate for each case. 

Nevertheless, we can only hope that Americans’ trust in our banking and financial systems can once again be restored. 

A New Arbitration Option for Investors

The Securities and Exchange Commission approved a Financial Industry Regulatory Authority, Inc. proposal giving investors the option to have an all-public arbitration panel. Traditionally, FINRA arbitration panels contain three arbitrators: two public arbitrators and one industry arbitrator—with a “nexus to the securities industry.” The public arbitrators are those who do not have any recent ties to the securities industry.

Over the last 27 months FINRA has been testing a voluntary pilot program that presented investors with the option to eliminate the industry arbitrator and replace that arbitrator with a public panelist. Results from the FINRA pilot program showed that the all-public option was chosen about 60 percent of the time. Further, the findings revealed that having the ability to choose the type of arbitration panel improved investor-claimant’s perception of the process.

The SEC cites in its approval that this new all-public option “will enhance the public’s perception that the FINRA securities arbitration process and rules are fair.” Some State regulators and other investor and consumer groups have long-advocated for all-public arbitration panels. The president of the North American Securities Administration Association, David Massey, further supports this move, but suggests that it should go one step further and allow investors to choose between arbitration and litigation.

Although there has been a big push for all-public arbitration panels, the shift has been controversial for some in the industry. Some industry arbitrators argue that because they know how things are supposed to run in the industry, they are in a unique position to be tougher on bad actors, and that they enhance the ability of the panel to reach the correct conclusion.

The option for an all-public arbitration panel is only applicable to future arbitrations and those currently pending before FINRA where the investor has not yet received a list of potential arbitrators. It is important to note that this change does not apply to investor arbitration proceedings in other arbitration forums, such as JAMS or the AAA. The rule change also does not affect disputes between brokerage firms or brokers.

Additional information about the new arbitration rules is available here.

New Year, New Fiduciary Standard?

It has been about six months since the passing of the Dodd-Frank financial reform law—and that means the results from the many studies commissioned by the Act will begin to be released. Dodd-Frank specifically required the Securities and Exchange Commission to look into regulatory standards and oversight gaps between investment advisors and brokers. Last week, the SEC released the results of its study on Section 913 and 914 dealing with the fiduciary duty issue and stricter investment-adviser examinations, respectively.

The issue of whether to impose a uniform fiduciary standard has been met with both fierce support and opposition. Currently, advisers are held to a fiduciary standard that requires them to act in the best interest of their clients, while brokers are only required to offer suitable products to retail customers. The problem with the dual standard arises where brokers offer advice and sell investment products—blurring the lines for retail investors and making it hard to tell when they are receiving sound investment advice or just a sales pitch.

However, last Friday, the SEC handed over its staff study to Congress recommending a uniform fiduciary standard. The study, if implemented as is, would hold brokers to the same fiduciary level as investment advisers under the Advisers Act when brokers are providing personalized investment advice about securities to retail investors. Therefore, under this study, brokers would only be held to a higher fiduciary duty when acting like an investment advisor.

Justification for a uniform standard stems from the issue of retail investors being unable to distinguish between a broker and an investment advisor. According to the SEC, if consumers are receiving investment advice, regardless of the source—broker or advisor—retail consumers should be protected uniformly. Accordingly, such a standard would achieve that goal. The SEC study also states that it attempted to balance retail investors’ need for protection with their ability to have access to various investment products. Because the standard only applied to brokers when giving investment advice, the SEC takes the position that a wide array of products will continue to still be available.

Further, in an attempt to close oversight gaps and keep implementation costs “to a minimum,” the SEC study also “recommends that when broker-dealers and investment advisers are performing the same or substantially similar functions” the regulatory protections should be “harmonized”, but the study lacks specific details on how to achieve this “harmonization.”

Ultimately, however, the staff study suggests additional research and analysis into this area before any implementation. Additionally, there is no statutory deadline for any follow-up rulemaking pursuant to this study, so it seems unlikely that much will be done without further research and analysis. SEC Commissioners Kathleen Casey and Troy Paredes share this view in their Statement Regarding Study on Investment Advisers and Broker-Dealers and emphasized the need for further research before any uniform fiduciary standard rulemaking begins.

Are You Doing Something That Requires Registration?

Not everyone involved in an investment transaction is an agent requiring registration. The activities requiring registration as an agent or broker is found in statute, common law and regulatory opinions. Although no single factor has been identified by these authorities to determine whether someone engaged in a financial transaction requires registration, factors given weight have been; whether the individual was involved in negotiations, solicited the investors, discussed the details of the investment, and if the person received compensation on a transaction-related basis.

Although Missouri has not statutorily or through administrative rulemaking defined those activities, there is guidance at the federal level from SEC No Action Letters and common law. In SEC v. U.S. Pension Trust Corp., No. 07-22570-CIV, 2009 WL 2365702 (S.D. Fla. July 30, 2009), the district court looked at several factors to determine whether a person’s activities were outside of the activities requiring registration as a broker. These factors include whether the person: (1) actively solicited investors; (2) advised investors as to the merits of an investment; (3) acted with “certain regularity of participation in securities transactions; and (4) received commissions or transaction based remuneration. U.S. Pension Trust, 2009 WL 2365702 at *9.

Two states provide a registration process for persons who participate in the offer or sale of securities who are not agents or brokers, Texas and Michigan. In Michigan these persons are “finders” and are defined as a person who, for consideration, participates in the offer to sell, sale, or purchase of securities or commodities by locating, introducing, or referring potential purchasers or sellers. Section 451.801, RSMi (Cum. Supp. 2008). Finders are included in the definition of investment adviser in the Michigan Securities Act and must register as such. In Texas, finders are defined as “An individual who receives compensation for introducing an accredited investor to an issuer or an issuer to an accredited investor solely for the purpose of a potential investment in the securities of the issuer, but does not participate in negotiating any of the terms of an investment and does not give advice to any such parties regarding the advantages or disadvantages of entering into an investment, and conducts this activity in accordance with §115.11 of this title (relating to Activities of a Finder). Note that an individual registered as a finder is not permitted to register in any other capacity; however, a registered general dealer is allowed to engage in finder activity without separate registration as a finder.” TX 7 CSR 7-115.1. Texas provides a registration process for finders.

The Missouri Securities Act contains exemptions for agent registration. The Act defines an agent in Section 409.1-102(1), RSMo, (Cum. Supp. 2008), as “an individual other than a broker-dealer, who represents a broker-dealer in effecting or attempting to effect purchases or sales of securities or represents an issuer in effecting or attempting to effect purchases or sales of the issuer’s securities.” Section 409.4-402. (a), RSMo (Cum. Supp. 2008), the registration provision for agents of broker-dealers in the Missouri Securities Act reads: “It is unlawful for an individual to transact business in this state as an agent unless the individual is registered under this act as an agent or is exempt from registration as an agent under subsection (b).”

The Missouri Securities Act’s exemption provision for agent registration found in Section 409.4-402(b) RSMo. (Cum. Supp. 2008), specifically provides in subdivision Section 409.4-402(b)(3), “an individual who represents an issuer with respect to an offer or sale of the issuer's own securities or those of the issuer’s parent or any of the issuer's subsidiaries, and who is not compensated in connection with the individual’s participation by the payment of commissions or other remuneration based, directly or indirectly, on transactions in those securities.” Moreover, subdivision (8) provides: “an individual who represents an issuer and who restricts participation to performing clerical or ministerial acts is exempt from registration.”

The prudent course of action is to evaluate your status and conduct and consult with counsel or your state regulator before you engage in any securities transaction as an unregistered person.