Securities Law Blog

On April 27, 2010 the Financial Industry Regulatory Authority (FINRA) fined five broker-dealers for the illegal sale of more than 8 billion shares of penny stocks on behalf of their customers. Fagenson & Co., Inc., RBC Capital Markets Corp., Equity Station, Inc., Olympus Securities, LLC and Alpine Securities Corp. have been fined a combined total of $385,000.

The majority of the illegal sales involved Universal Express Inc. More than 7.5 billion shares of the company’s unregistered stock were sold by the five firms, generating proceeds of roughly $8.4 million.

Regulators allege that despite indications that the sale of the stock was potentially illegal, the firms failed to take appropriates measures to determine whether the sale of the securities followed federal registration requirements.

In 2004 the Securities and Exchange Commission (SEC) filed a complaint alleging that Universal had issued more than 500 million shares of unregistered stock for distribution to the public. In 2007, a federal court ordered Universal to pay an estimated $22 million in fines and disgorgement. Despite the actions taken against Universal, the five firms carried out most of the illegal sales after the SEC’s complaint or after its enforcement action.

All of the firms, except Equity Station Inc., were found to have failed to establish and enforce a reasonable supervisory system to prevent the sale of unregistered stock.

“Brokerage firms are the first line of defense when it comes to preventing the illegal distribution of unregistered securities into the public markets. The failure to detect and prevent these sales creates serious risks to the unsuspecting customers who purchased these unregistered securities,” said James Shorris, FINRA Executive Vice President and Executive Director of Enforcement.

FINRA found that each of the five firms allowed their customers to deposit large blocks of thinly traded securities in certificate form and then immediately liquidate those positions.

According to the FINRA report, Fagenson reported earning $44,000 in commissions and was fined $165,000; RBC earned $68,000 in commissions and was fined $135,000; Alpine earned $47,000 and was fined $40,000; Equity earned $13,575 and was fined $25,000; and Olympus earned $5,200 and was fined $20,000.

A 2007 lawsuit filed against the Financial Industry Regulation Authority (FINRA) was dismissed on March 1, 2010. The suit stemmed from a complaint that National Association of Securities Dealers (NASD) members were misled during the 2007 merger of the NASD and the regulatory arm of NYSE. The plaintiffs, Standard Investment Chartered Inc. and Benchmark Financial Services Inc., each filed class-action lawsuits in 2007 and 2008 respectively.

Judge Jed S. Rakoff, of the U.S. District Court for the Southern District of New York, held that the NASD, now known as FINRA, has immunity from “private damage suits challenging official conduct performed within the scope of their regulatory functions.”

The lawyers for the plaintiffs argued that their claim was unrelated to the organization’s regulatory function. Instead it was based on allegedly misleading statements made by the NASD and its executives regarding their finances.

The disputed issue was the adequacy of the $35,000 payout received by NASD member firms at the completion of the merger. The intent of the payout was to compensate members in exchange for giving up significant voting rights under the new FINRA corporate structure. Both plaintiffs said the NASD allegedly misled its members by telling brokerages that due to Internal Revenue Service (IRS) rules governing non-profits, the $35,000 payout was the maximum it could dish out to each member firm.

According to Jonathan Cuneo, lawyer for Benchmark Financial and Standard Investment, a March 2007 IRS letter to FINRA gave a very different range of permissible payouts. Allegedly the letter showed that the NASD could have paid brokerages between $70,000 to $111,000 each. However, the letter was sealed in 2007 by another U.S. District Judge, the late Shirley Whol Kram, with the dollar amounts of the possible payments redacted. Judge Kram’s reasoning was that disclosure of the IRS payment range would harm the NASD’s competitive advantage.

The Financial Industry Regulatory Authority (FINRA) recently released a regulatory notice to remind firms of their responsibilities when dealing with deferred variable annuities. FINRA outlines several steps that ought to be taken in order to ensure customer suitability when buying deferred variable annuities and compliance measures that can be set up by the firm.

The recommendation requirements state that:

*No recommendation of the purchase or exchange of a deferred variable annuity shall be made unless a member or person associated with a member has reasonable basis to believe that the customer has been informed of various features of deferred variable annuities, and that the customer would benefit from certain features of deferred variable annuities.

*Prior to recommending the purchase, the associated person must research the customer’s background and needs. Such fields should include but are not limited to age, income, financial situation, investment experience/objectives, assets and risk tolerance.

*After receiving necessary information, the application should be submitted to the firm’s office of supervisory jurisdiction (OSJ).

*A registered principal shall review and determine whether he/she approves the recommended purchase or exchange of the deferred variable annuities prior to submitting to the insurance company.

*Each suitability determination should be documented and signed by the person recommending, approving or rejecting the transaction.

FINRA also reminds firms that it is their responsibility to establish and maintain specific supervisory procedures reasonably designed to achieve compliance. Surveillance procedures should be implemented to prevent inappropriate exchanges and corrective measures should be in place to deal with inappropriate conduct.

Training policies or programs should be developed and documented to ensure that persons who effect and those who review transactions dealing with deferred variable annuities comply with the requirements of this Rule and understand material features of deferred variable annuities.

Since the boom of investment fraud uncovered during the financial crisis, lawmakers and state securities regulators are attempting to assume oversight of many investment advisers currently under the supervision of the Securities and Exchange Commission (SEC).

According to the testimony given by Texas Securities Commissioner and the North American Securities Administrators Association (NASAA) President Denise Voigt Crawford, “As the regulators closest to the investors, state securities regulators provide an indispensable layer of protection for Main Street investors.”

Crawford was one of many industry leaders to testify before the U.S. Financial Crisis Inquiry Commission (FCIC) during its first round of hearings in January 2010. The FCIC is a 10-member bipartisan panel established to examine the cause of the financial crisis with the intention of producing a report offering recommendations to prevent a reoccurrence.

The financial regulation proposals in Congress could bring about 4,000 advisers who manage between $25 million and $100 million in assets under the supervision of state regulators, according to NASAA. Currently the SEC says it inspects from 9% to 12% of the 11,000 advisory firms it oversees. Allowing each state to oversee anywhere up to around 600 additional advisers, as would be the case in California, would lead to more frequent examinations. State regulators are in the process of generating a mutual agreement to cooperate with one another in policing additional advisers if the proposal passes.

“Our presence did not contribute to the crisis; rather, the fact that our regulatory and enforcement roles have been eroded was a significant factor in the severity of the financial meltdown,” testified Crawford.

Since the passage of the National Securities Markets Improvement Act of 1996 (NSMIA), the responsibility of enforcement shifted from state to federal government. Now the states are fighting to get it back.

The NASAA President offered a series of recommendations to improve the ability of state regulators to pursue financial fraud. A few of these recommendations include: restoring state regulatory oversight of all Regulation D Rule 506 offerings; increasing state regulation of investment advisers; reexamining and removing the hurdles facing securities plaintiffs in private actions; and providing additional resources to uncover and prosecute securities fraud cases.

Robert Khuzami is making big moves in his first year at the helm of the Securities and Exchange Commission (SEC)’s enforcement division. The director has helped to lead the largest overhaul of the SEC in the last thirty years. Trying to move on from the SEC’s devastating missteps surrounding the Madoff scam, the changes in the enforcement division will seek to stop financial criminals in their tracks.

Khuzami’s new “whistle-blower initiative” aims to catch crooks before they have caused too much damage. The initiative is directed at individuals involved in perpetrating the scams. For those who participate in fraudulent schemes but now wish to turn in their co-conspirators, the SEC is offering escalated levels of protection. The whistle-blower’s help will be taken into consideration when taking enforcement action in what the SEC is calling “cooperation agreements.” These agreements could exempt the whistle-blower from SEC suits and provide legal help if the U.S. Department of Justice were to launch its own criminal case.

Another part of Khuzami’s revitalization efforts include pushing for legislation to add whistle-blower payments and protections to U.S. securities laws. The proposed legislation would offer big economic incentives for securities tattletales. If passed into law, an individual who provided crucial information that led to the capture of a felon could collect an award worth up to 30% of the amount regulators later recover from the scam.

According to Khuzami, having an insider will make uncovering the well-hidden tracks of white-collar criminals much easier.

“People who engage in a lot of white-collar crimes are often planning their defense at the same time as they are planning their offense,” Khuzami said.

The SEC restructuring comes after one of the worst years for securities fraud. According to “Select SEC and Market Data 2009”, the SEC:

*Obtained orders in SEC judicial and administrative proceedings requiring securities violators to disgorge illegal profits of approximately $2.09 billion and to pay penalties of approximately $345 million.

*Sought emergency relief from federal courts in the form of temporary restraining orders to halt ongoing fraudulent conduct in 71 actions, and sought asset freezes in 82 actions.

*In SEC-related criminal cases, prosecutors filed indictments, informations, or contempts in the 2009 fiscal year in 154 cases.

The regulatory agency has never before caught as many crooks or ordered as much money returned to investors. The numbers also reflect that millions of investors lost billions of dollars before the crooks were caught, and will be lucky to recover what little they can.

What could derail the SEC and Khuzami’s entire initiative? The current federal prison sentence being served by former international banker, Bradley Birkenfeld. Birkenfeld turned in his bosses at Swiss banking agent UBS, leading to one of the largest IRS settlements in history. Supporters of Birkenfeld are seeking a pardon for him as a reward for his cooperation with the government. Despite his cooperation, the Justice Department sought prison time for Birkenfeld, saying he turned in his superiors but did not disclose his own role in helping one of his clients.

Although Khuzami had no role in the Birkenfeld case, the SEC could face problems in launching a successful whistle-blower program while one whistle-blower is sitting in federal prison.