Securities Law Blog

The appellate body of the Financial Industry Regulation Authority (FINRA) issued a ruling dismissing the charges against two senior personnel of Knight Securities, Kenneth Pasternak and John Leighton. The National Adjudicatory Council (NAC) reversed an earlier FINRA Hearing Panel decision that found the former CEO and the head of the firm’s Institutional Sales Desk, responsible for supervisory failures.

The original charges filed against Mr. Pasternak and Mr. Leighton stemmed from a March 2005 charging memorandum which alleged that “Pasternak and Leighton did not take reasonable steps to ensure that Knight Securities’ leading institutional sales trader adhered to ‘industry standards’ when executing orders for institutional customers.”

The NAC determined that FINRA failed to satisfy its burden of proof in relation to the 2005 allegations. According to the NAC, the evidence presented by FINRA did not support the claim that Mr. Pasternak and Mr. Leighton failed provide reasonable supervision, nor did it support allegations that Mr. Pasternak did not respond appropriately to “red flags” in relation to the sales trader’s execution of institutional customer orders.

The $100,000 fines, and other sanctions imposed on the two men were vacated by the NAC’s ruling.

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 Securities and Exchange Commission (SEC) charged State Street Bank and Trust Company on February 4, 2010 with misleading its investors in the Limited Duration Bond Fund. State Street created The Limited Duration Bond Fund (the “Fund”) in February 2002, and marketed it to investors as an alternative to a money market fund, claiming to have better sector diversification.

In 2006 and early 2007, State Street increased the investors’ exposure to subprime mortgages, while investors remained unaware of the extent to which their investments were tied to the money-losing loans. The Fund continued to be marketed to prospective investors without disclosing the extent of the fund’s concentration in subprime investments, according to the SEC complaint.

When the market meltdown began happening in July 2007, State Street provided selected investors with more complete information about the Fund, while allegedly keeping others in the dark. The informed investors are said to include clients of State Street’s internal advisory groups, who paid more for consulting services. According to the Complaint, these investors were informed by late July to exit the fund, while others were encouraged to stay and continue to invest. State Street began selling the fund’s most liquid holdings in order to meet the redemption demands of the more informed investors. The Fund was left with mostly illiquid holdings and cost investors millions of dollars.

Neither admitting or denying guilt, State Street agreed to settle the SEC’s charges by paying $313 million to allegedly misled investors who lost money during the meltdown. Making up the $313 million is a $50 million penalty, $8.3 million in disgorgement and prejudgment interest, and $255 million to investors. Prior to the SEC’s recent charges, State Street has already agreed to pay nearly $350 million to settle private lawsuits.

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.

In the first wave of so-called Madoff “clawback” lawsuits, the trustee liquidating Bernard L. Madoff Investment Securities LLC sued Stanley Chais and other defendants over claims they received more than $1 billion as “insiders” in the Ponzi scheme.

Similar lawsuits will be filed in coming weeks and months, said the trustee, Irving Picard, in an e-mailed statement. Chais is a philanthropist and investment adviser based in Los Angeles. The suit named Chais, his companies including Brighton Co., and trusts in family members’ names.

“Stanley Chais was a beneficiary of this Ponzi scheme for at least thirty years,” Picard said in the Complaint. Since December 1995, Chais and the other defendants “collectively profited from this scheme through the withdrawal of more than one billion dollars, and knew or should have known that they were reaping the benefits of manipulated purported returns, false documents and fictitious profits.”

Picard, a lawyer with Baker & Hostetler LLP in New York, has recovered about $1 billion for investors in Madoff’s money- management business, known by its initials as BLMIS.

“This is the first of several actions that will be brought against entities that either acted as insiders with Bernard Madoff and BLMIS or that benefited from Madoff’s scheme to the severe detriment of other customers of BLMIS,” an attorney for Picard, said in the statement.

The case is Picard v. Chais, 09-01172, and the bankruptcy case is Bernard L. Madoff, 09-11893, U.S. Bankruptcy Court, Southern District of New York (Manhattan).