Securities Law Blog

On June 30, 2010 the Securities and Exchange Commission (SEC) approved new rule that will have a significant impact on the ability of investment advisers to make monetary contributions to elected officials or candidates, who are in a position to influence the selection of an adviser for government investment accounts.

There are three key elements of the SEC rule designed to direct political contributions by investment advisers, and prevent ways that advisers may engage in pay to play actions.

According to the SEC, the first part of the rule prohibits an investment adviser from providing advisory services for compensation for two years, if the adviser or its executives or employees make a political contribution to an elected official who is in a position to influence the selection of an adviser.

The second element prohibits an advisory firm and certain executives and employees from soliciting or coordinating campaign contributions from others for an elected official who is in a position to influence the selection of an adviser. It also prohibits solicitation and coordination of payments to political parties in the state or locality where the adviser is seeking business.

The final part prohibits an adviser from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser, unless that third party is an SEC-registered investment adviser or broker-dealer subject to similar pay to play restrictions.

When the new rule becomes effective, an investment adviser who makes a political contribution to an elected official in position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

One provision to the SEC rule permits an executive or employee to make contributions of up to $350 per election per candidate if the contributor is entitled to vote for the candidate, and up to $150 per election per candidate if the contributor is not entitled to vote for the candidate.

SEC Chairman Mary L. Shapiro said, “These new rules will help level the playing field, allowing advisers of all sizes to compete for government contracts based on investment skill and quality of service.”

The new SEC rule comes at a time when cases related to “pay to play” practices have been popping up all over the nation. Most recently filed was the SEC case against the New York State Common Retirement Fund over alleged kickbacks connected to investments.

Forty- nine broker-dealers that sold the private placements issued by Provident Royalties LLC have been named in a lawsuit filed in a Dallas bankruptcy court. On June 21, 2010 the liquidating trustee Milo H. Segner Jr. filed the lawsuit in an attempt to get back $285 million in claims and commissions from the firms.

Mr. Segner alleges that the firms “failed miserably in upholding their fiduciary obligations” when selling the series of Provident Royalties LLC private placements.

The trustee’s lawsuit is on behalf of investors who bought roughly $251 million of the Reg D offerings and paid around $34 million in commissions to the broker-dealers and their representatives.

According to the lawsuit, “The commissions, fees and payments received from Provident Royalties encouraged and played a substantial role in the negligent and/or grossly negligent conduct of the broker-dealers.”

The Securities and Exchange Commission (SEC) charged Provident and its executives with fraud in running a $485 million Ponzi scheme based on phony investments. An estimated 7,700 investors bought the private placements from June 2006 to January 2009.

Former Deutsche Bank Securities broker Edward S. Brokaw has been permanently barred from the securities industry for manipulating the price of Monogram Biosciences (MGRM) stock. On June 29, 2010 a Financial Industry Regulatory Authority (FINRA) hearing panel found that the broker, based in the Greenwich, CT branch office of Deutsche Bank, ordered trades of MGRM stock in a deliberate attempt to drive down the value of the stock, which would drive up the value of the contingent value rights (CVRs) on that stock.

MGRM CVRs were created after the merger of two firms to form MGRM in 2004. The CVRs were to be valued during a 15 day period beginning May 19, 2006 and ending June 9, 2006. During the 15 day period the value of the CVRs was to be determined by the volume weighted average price (VWAP) of MGRM shares. At the end of the pricing period CVR holders would receive payment from MGRM.

According to the FINRA report, “If the final VWAP was at or above $2.90, the CVRs would be worthless. But if the final VWAP was below $2.90, CVR holders would receive a penny-for-penny payment for the amount below $2.90, down to $2.02.”

Evidence before the FINRA panel included recorded phone calls from Brokaw to the firm’s trading desk to place sell orders. The calls allegedly explained the pricing of the CVRs and the hedge fund’s instructions to sell close to the market’s open and close.

One such phone call placed by Brokaw to a Deutsche Bank sale trader said, “Take 50,000 MGRM at the market. Sell it down. Sell it as low as you want. Sell it hard, 50,000.”

The FINRA hearing panel concluded that “the objective of the selling strategy was to drive down the price of MGRM shares rather than to obtain the best price…(Brokaw) placed the orders to artificially depress the price of MGRM to impact the pricing of the CVRs.” According to the panel, for every penny that MGRM stock dropped, the hedge fund lost $29,000 in value on its shares but gained more than $180,000 in value on its CVRs.

Brokaw’s aggressive trading strategy continued for three days until Deutsche Bank’s compliance personnel reviewed the trade orders and stopped executing MGRM sales for the hedge fund’s account. Deutsche Bank then suspended, and subsequently terminated Brokaw.

At the time the pricing period began, the hedge fund represented by Brokaw held 18.5 million CVRs. If the shares had dropped below the specified price point, the hedge fund stood to gain a maximum payout of about $16 million at the end of the period. Brokaw and his family had a potential gain of about $188,000.

On Friday June 25, 2010, after a three week trial, U.S. District Judge John Koeltl dismissed the lawsuit against Deutsche Bank AG salesman Jon-Paul Rorech and former Millennium Partners LP portfolio manager Renato Negrin. The case marked the first insider trading enforcement action involving credit default swaps (CDS) filed by the Securities and Exchange Commission (SEC).

The original complaint, filed in May 2009, is based on the 2006 buyout of VNU N.V., an international holding company that owned Nielsen Media and other media businesses, by a group of six private-equity firms. The SEC alleged that Rorech learned information from Deutsche Bank investment bankers about a change to the proposed VNU bond offering, on which Deutsch Bank was the lead underwriter, which was expected to increase the price of CDS on VNU bonds. Rorech allegedly tipped off Negrin about the potential change to the bond structure, after which Negrin purchased CDS on VNU for a Millennium hedge fund.

After the announcement of the restructuring became public, the price of VNU CDS significantly increased, generating a $1.2 million profit at the close of Millennium’s VNU CDS position.

The SEC alleged that Rorech and Negrin shared confidential information via telephone on a recorded landline and twice switched to their cell phones, apparently showing that they knew what they were doing was wrong.

Judge Koeltl rejected the recorded calls as substantial evidence to insider trading stating that “the SEC attempts to attribute nefarious content to those calls through circumstantial evidence, there is, in fact, no evidence to support this inference and ample evidence that undercuts the SEC’s theory that the defendants engaged in insider trading.”

Part of Rorech and Negrin’s defense argued that the SEC had no jurisdiction over the CDS because they are private contracts, not securities. Judge Koeltl however agreed with the SEC’s jurisdiction because the swaps are “security-based.”

“The material terms of VNU CDS contracts were based on the price, yield, value, or volatility of VNU’s securities,” the Judge said. “Therefore, the CDS at issue in this case are security-based swap agreements” and are subject to the federal securities laws.

There is no word yet on whether the SEC will appeal the decision.

A Canadian couple and the two companies they controlled have been charged with four counts of fraud for using their Penny Stock Chaser Web site and social media sites to tout penny stocks. The Securities and Exchange Commission (SEC) filed its complaint against Carol McKeown and Daniel F. Ryan on June 29, 2010 in the U.S. District Court for the Southern District of Florida. Although the couple resides in Canada the SEC is pursuing the case in Florida because many of the trades were made in Boca Raton.

The complaint states that McKeown and Ryan allegedly used their web site www.pennystockchaser.com to invite investors to sign up for daily stock alerts through email, text messages, Facebook and Twitter. The couple residing in Montreal, Canada allegedly used all modern methods to promote a half-dozen companies’ stocks, while failing to properly disclose to investors that they were regularly selling shares in those same companies, in a process known as “scalping”, according to the SEC.

The SEC stated in its complaint that the statement on the Penny Stock Chaser website was insufficient disclosure because of the “massive” and regular quantities of stock the couple sold. The statement from the website said that Penny Chaser Stock “may be selling shares of stock at the same time the profile is being disseminated to potential investors; this should be viewed as a definite conflict of interest and as such, the reader should take this into consideration.”

Penny Stock Chaser began peddling the stocks of at least 65 American companies in the spring of 2009. The couple allegedly used two entities they controlled, Meadow Vista Financial and Downshire Capital to sell those same stocks. Six of the companies mentioned in the complaint that Penny Chaser fraudulently touted are Converge Global, Biocentric Energy Holdings, Bluewave Group, Avro Energy, Atlantic Wind & Solar, and MSE-Enviro-Tech. The SEC alleges that the scalping scheme related to these companies alone netted the pair at least $2.4 million in profit.

According to the SEC, the scheme prospered as a result of McKeown and Ryan buying shares of stocks they would then tout. The penny stocks would go up as a result of investor demand, and the couple would then allegedly sell their shares and receive their profit.

The Penny Stock Chaser operation caught the eye of regulators when shares in General Motors inexplicably kept rising despite their filing for bankruptcy and splitting itself into two companies in 2009.

The SEC is charging McKeown, Ryan, Downshire Capital Inc. and Meadow Vista Financial Corp. with violating federal securities laws. The regulator seeks disgorgement of ill-gotten gains plus prejudgment interest and the imposition of a financial penalty, penny stock bars against the individuals and the repatriation of assets to the United States.