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.

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.

Increasing numbers of complaints from investors concerning sales of private placements has brought more cases against brokerage firms involved in selling private placement or Regulation D offerings. The representatives marketing these offerings are also being singled out by defrauded investors.

In the U.S. District Court in Boise, Idaho, a group of investors have filed a lawsuit against their adviser, Bradley Hofhines, and his firm, Summit Retirement Advisers LLC. The claimants allege that Hofhines failed to disclose that returns from investments in Provident Royalties LLC securities were not in fact profits generated by investments in oil and gas properties but instead were a Ponzi-esque mixture of investor funds and proceeds of later offerings.

The lawsuit also names affiliates of Hofhines, including Securities America Inc., the firm’s broker-dealer, as well as Ameriprise Financial Inc., which owns Securities America Inc. The broker-dealer and its parent company could be liable for failure to supervise the representative. While the degree of participation of each party has yet to be uncovered, Securities America has been named in two other lawsuits related to private placements gone askew.

In Hofhine’s statement, he claimed to have done the right thing when selling the Provident shares.

“I will say that I sold the product properly, given the information I had and the due diligence that was performed on this company,” Hofhine stated. “I certainly had no way of predicting or uncovering the alleged intentional fraud at Provident, nor how the economic collapse has magnified the problems.”

Another major bump in the road for Hofhine and Securities America is that they allegedly sold Provident securities to more than 35 non-accredited investors. Typically most investors who buy private placements or ‘Reg D’ offerings must be considered ‘accredited’; individuals with more than $1 million in assets.

Securities America’s executive vice president and chief marketing officer, Janine Wertheim, commented by saying “Each private-placement transaction of this type is reviewed on an individual basis to determine accredited investor status and requires evidence of eligibility to purchase the product.”

Now less than two months later, Securities America finds itself in more hot water, this time with the Massachusetts Securities Division.

The complaint charges that the broker-dealer misled investors when it sold them private-placement securities. It alleges that when it sold promissory notes issued by Medical Capital Holdings Inc. as private placement securities totaling $697 million, Securities America made “material omissions and misleading statements”. The broker-dealer is also said to have disregarded due-diligence recommendations to share financial information with investors.

Securities America sold 37% of the estimated $1.7 billion in notes from 2003 to 2009 issued by Med Cap. More than 60 Massachusetts investors bought approximately $7.2 million of the notes sold by Securities America, according to the Securities Division.

The Massachusetts Securities Division is seeking a cease and desist order and an administrative fine against Securities America, as well as restitution for all Massachusetts investors who bought the notes.

This case comes at a time when the Financial Industry Regulatory Authority (FINRA) is stepping up its efforts to investigate more and more allegations of misconduct arising from the sale of ‘Reg D’ private placements.

James Shorris, executive vice president and executive director of enforcement at FINRA, stated that the industry regulator will be continuing to focus their attentions on whether the brokers made any misrepresentations during a sale, whether they performed due diligence with the products sold, and whether firms adequately supervised sales of the products. FINRA will also be taking into consideration the suitability of the sales made to customers.