Author: Andrew L. Van Houter

D.C. Circuit Split on Constitutionality of SEC’s Administrative Judges

We previously blogged about the D.C. Circuit’s decision in Raymond J. Lucia Cos v. SEC, which rejected the petitioner’s constitutional challenges to the SEC’s use of administrative law judges that are not appointed by the President. Yesterday, the D.C. Circuit issued a two sentence per curiam order denying an en banc review by an equally divided court.

We noted that the panel’s original opinion was the first appellate ruling of its kind. Although the panel’s decision remains in effect because the full court did not rehear the case, the strength of that ruling is now severely undermined. As we previously reported, the Tenth Circuit has already disagreed with the D.C. Circuit’s panel and held that the SEC’s administrative law judges are subject to the Constitution’s Appointments Clause. Yesterday’s order likely sets the stage for a Supreme Court challenge.

Broker Pays $2.5 Million Fine for Using Market Volatility to Hide Markups Yielding Unearned Commissions

Last week, Louis Capital Markets, L.P. (“LCM”) agreed to disgorge $2.5 million in settlement of charges that it charged false execution prices to its customers in order to generate secret commissions.

LCM executed orders to purchase and sell securities for its clients, without holding any securities in its own account and thus bore no market risk, i.e., riskless principal trades. It purported to generate profits by charging customers small commissions, typically between $0.01 and $0.03 per share. LCM, however, unbeknownst to customers, inflated those commissions, by embedding undisclosed markups and markdowns into reported execution prices. LCM provided those false execution prices—either lower sales prices or higher purchase prices than LCM actually obtained in the market—to its customers. Critically, LCM did not engage in this deceptive behavior for every trade, rather “LCM opportunistically added markups/markdowns to trades at times when customers were unlikely to detect them, for example, during periods of market volatility.” (Order ¶ 13.) By engaging in these acts, LCM “unlawfully obtained millions of dollars from its customers.” (Order at 2.)

Without admitting or denying the findings, LCM agreed disgorge $2.5 million and to cease-and-desist violating Section 15(c)(1), which prohibits fraudulent conduct by broker-dealers. The SEC noted that while the conduct would support a civil penalty, it considered LCM’s financial status and accepted LCM’s offer that did not include one. Interestingly, LCM’s customers were “primarily large foreign institutions and foreign banks,” demonstrating the SEC’s commitment to eradicate fraud regardless of sophistication of investors.

District Court Invalidates Tolling Agreements in Criminal Securities Fraud Prosecution Case Due to Misunderstanding of Applicable Statute of Limitations

On January 30, 2017, the United States District Court for the District of New Jersey dismissed the government’s indictment against Guy Gentile for a pump-and-dump securities fraud scheme. After his arrest Gentile admitted to having engaged in the scheme and agreed to cooperate, which included signing two tolling agreements, each extending the statute of limitations for one year. In dismissing the indictments, the court held that the tolling agreements were invalid and the applicable statute of limitations for securities fraud was five years, not six years.

According to the opinion, Gentile engaged in a securities fraud scheme that indisputably ended in June 2008, at which time the statute of limitations for securities fraud was five years. In 2010, however, the Dodd-Frank Wall Street Reform and Consumer Protection Act extended the statute of limitations to six years for certain criminal securities fraud violations. Gentile was charged on June 25, 2012 and arrested on July 13, 2012, i.e. four years after the criminal conduct. Under interrogation, Gentile admitted to the fraud and agreed to cooperate with the government. Gentile entered into a tolling agreement with the government that tolled the limitations period from July 31, 2012 through July 31, 2013. Gentile subsequently signed a second tolling agreement, tolling the limitations period from July 31, 2013 through July 31, 2014. Gentile, however, refused to sign a third tolling agreement because he wanted all cooperation and criminal actions to be concluded by June 30, 2015. Critically, when entering the tolling agreements, both the government and Gentile assumed the statute of limitations was five years (the limitations period in effect at the time of the criminal conduct) and not six years (the limitations period in effect at the time of the arrest). Accordingly, at the time that the second tolling agreement expired, the government would have had to indict Gentile prior to July 31, 2015.

Unable to reach a plea deal, the government indicted Gentile in March 2016 and Gentile moved to dismiss. If the statute of limitations had been six years, the second tolling agreement would have presumably given the government until July 31, 2016 to indict. The court, however, disagreed. The court first found that, “limited to the specific facts of this case,” the tolling agreements were invalid because Gentile did not have a full understanding of the waiver. Slip Op. at 6. The court reasoned that “the waivers were executed unknowingly since Defendant clearly thought he was extending his exposure to criminal prosecution by two years when in fact, if the statute of limitations was six years, he was extending the period of exposure by three years.” Slip Op. at 7. That misunderstanding rendered the waivers invalid, with the effect that the statute of limitations was not tolled. Without a toll, the government’s deadline to indict was either June 30, 2013 (under the five-year limitations period) or June 30, 2014 (under the six-year limitations period). In either event, the March 2016 indictment was untimely.

After holding that the defendant’s ignorance of the potential six-year limitations period rendered the tolling agreements invalid, the court then held that the applicable statute of limitations is in fact five years, i.e., exactly what the Gentile had thought when he entered the tolling agreements. The court relied on the presumption against retroactivity absent express congressional intent. Since the applicable section of the Dodd-Frank act “contains no discussion nor mention of retroactivity, let alone clear intent that Congress intended th[e] section to apply to crimes committed prior to its enactment[,]” the six-year limitations period is not retroactive. Because the applicable statute of limitations was five years, even if the tolling agreements were valid, the indictment was untimely, as the tolling agreements would have only extended the statute of limitations until June 30, 2015.

Update: SCOTUS Will Consider Statute of Limitations on Disgorgement

We previously wrote about how the SEC urged the Supreme Court to grant certiorari in Kokesh v. SEC, and on Friday, January 13, the Court did just that. In an order without comment, the Court granted certiorari after both the petitioner and the SEC requested the Court’s review, albeit for different reasons. While the petitioner believes he should not be subject to disgorgement for ill-gotten gains that were obtained more than five years ago, the SEC wants the Court to bring clarity to the circuit split that has developed since the Eleventh Circuit’s decision in SEC v. Graham, which held that the five-year statute of limitations applies to disgorgement. As we previously noted, the SEC argued that Graham impedes its ability to achieve uniformity in the administration of securities laws.

We will continue to monitor developments in this case, which is sure to shape the timing of future SEC enforcement investigations and actions and the remedies it will seek.

SEC Urges Supreme Court to Consider Nature of Disgorgement

We previously posted about how the Southern District of Florida’s and Eleventh Circuit’s decisions in SEC v. Graham undermined the SEC’s long-held position that disgorgement was not subject to the five-year statute of limitations. The SEC recently asked the Supreme Court to examine that decision by joining the petitioner’s request for certiorari in Kokesh v. SEC, a case in which the Tenth Circuit affirmed an award of disgorgement, holding that the five-year statute of limitations did not apply.

In Kokesh, the SEC obtained a final judgment in 2014 that included nearly $35 million of disgorgement that covered ill-gotten gains obtained as far back as 1995. The Tenth Circuit affirmed the final award, diverging with Graham, and holding that disgorgement was not a penalty or forfeiture to which the five-year statute of limitations applied.  Kokesh applied for certiorari.

Last week, the SEC urged the Supreme Court to take the case. While briefly stating that the Tenth Circuit correctly ruled that disgorgement is not a penalty or forfeiture to which the statute of limitations applies, the SEC argued that “the issue is important to the administration of the securities laws, and the courts of appeals have reached conflicting conclusions” thereby warranting the Court’s review. Without the Supreme Court’s resolution, the SEC argued that it “is currently impeded by the decision in Graham from obtaining the full disgorgement remedies to which it is entitled” and described Graham as “a significant obstacle to national uniformity in administration of the securities laws.”

If the Supreme Court takes the case, the decision will directly impact the timing of SEC enforcement investigations and actions, as well as the types of remedies the SEC will seek. If the Court declines to grant certiorari, the SEC will likely try to seek different remedies in different jurisdictions for the same conduct. In the meantime, the SEC has increased its requests for tolling agreements in ongoing investigations in an apparent attempt to preserve its ability to seek the full range of remedies in the event that the investigation leads to the filing of an action.

SEC Affirms Commitment to FCPA Enforcement Actions

Andrew J. Ceresney, Director of the Division of Enforcement, reaffirmed the SEC’s focus on FCPA enforcement actions at the International Conference on the Foreign Corrupt Practices Act. Mr. Ceresney’s speech focused on companies’ need to self-report violations.

Mr. Ceresney stated that the SEC uses “a carrot and stick approach to encouraging cooperation,” where self-reporting companies can receive reduced charges and deferred prosecution and non-prosecution agreements, while companies that do no self-report do not receive any reduction in penalties. Mr. Ceresney warned that “companies are gambling if they fail to self-report FCPA misconduct.”

Mr. Ceresney gave examples of how this policy has benefited companies recently. Mr. Ceresney highlighted the SEC’s decision not to bring charges against the Harris Corporation after it self-reported violations and mentioned to examples where the SEC entered into non-prosecution agreements as a result of self-reporting.

Mr. Cerseney stated that the SEC’s “actions have sent a clear message to the defense bar and the C-Suite that there are significant benefits to self-reporting [to] and cooperation with the SEC” and that he expects “the Division of Enforcement will continue in the future to reinforce this message and reward companies that self-report and cooperate.”

Mr. Cerseney also spoke about recent cases that highlight “the Enforcement’s Division’s renewed emphasis on individual liability in FCPA cases[,]” noting that seven actions in the past year involved individuals. Mr. Cerseney stated that “pursuing individual accountability is a critical part of deterrence and . . . the Division of Enforcement will continue to do everything we can to hold individuals accountable.”

Mr. Cerseney’s remarks demonstrate that the Division of Enforcement does not expect to change its recent focus on FCPA violations and individual liability as it transitions to the new administration.

Third Circuit Defined “Investment Adviser” In Sentencing Appeal

Everett C. Miller pleaded guilty to securities fraud after he sold more than $41 million in phony, unregistered promissory notes in his firm, Carr Miller Capital, LLC, that falsely promised high returns with no risk. As part of his plea, Miller and the government stipulated to what they considered to be an appropriate offense level under the United States Sentencing Guidelines (the “Guidelines”). At sentencing, however, the district court applied the four-level investment adviser enhancement provided for by the Guidelines for securities laws violations perpetrated by “investment advisers,” as that term is defined by the Investment Advisers Act of 1940, 15 U.S.C. § 80b-2(a)(11). See U.S.S.G. § 2B1.1(b)(19)(A)(iii). Due to the enhancement, Miller received a 120-month sentence.

On appeal, Miller challenged, among other things, the application of the investment adviser enhancement, arguing that he was not an “investment adviser” under the Investment Advisers Act. The Investment Adviser Act defines “investment adviser,” in part, as a person who “for compensation engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.” 15 U.S.C. § 80b-2(a)(11). Miller argued that he was not “in the business” of providing securities advice; he did not provide advice “for compensation”; and he was not a registered investment adviser.

The Third Circuit first ruled that Miller was in the business of providing securities advice. In so concluding, the Third Circuit looked to a 1987 SEC interpretive release (the “SEC Release”) that stated the SEC considers a person who “holds himself out as an investment adviser or as one who provides investment advice” to be in “in the business.” Applying that guidance, the Third Circuit found that Miller was in the business of providing securities advice because he held himself out as an investment adviser in personal meetings with investors and because he was associated with a registered investment adviser.

The Third Circuit also relied on the SEC Release to conclude that Miller provided the advice “for compensation.” The SEC Release defines compensation as “any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services rendered, commissions or some combination of the foregoing.” The Third Circuit found that the investors’ principal on the promissory notes “became Miller’s compensation—his ‘economic benefit’—when he comingled investors’ accounts and spent the money for his own purposes.”

Finally, the Third Circuit rejected Miller’s argument that he could not be considered an “investment adviser”  solely based upon his association with an investment adviser. The Third Circuit ruled that “[r]egistration is not necessary to be an ‘investment adviser’ under the Act” and thus “Miller was an ‘investment adviser’ under the Act, despite his failure to register as such.”

Given the facts of this case, and the interpretative guidance on which the Court relied, the decision does not come as a surprise.

Third-Party Service Provider to Private Equity Funds Pays More Than $350,000 for Gatekeeping Failures

On June 16, 2016, Apex Fund Services (US), Inc., settled charges that it ignored clear indications of fraud while keeping records and preparing financial statements and investment account statements for private funds managed by EquityStar Capital Management, LLC, and ClearPath Wealth Management, LLC, each of which has previously been charged with fraud in SEC enforcement actions. Press Release 2016-120. The settlement highlights the SEC’s focus on gatekeepers and the importance of gatekeepers monitoring red flags, especially when their role includes providing financial information to investors.

With respect to EquityStar, Apex settled charges that it made materially false and misleading statements to investors when it improperly accounted for undisclosed withdrawals from funds (made by EquityStar and manager Steven Zoernack) as receivables even when Apex possessed evidence that neither EquityStar nor Zoernack were willing or able to repay the withdrawals, which totaled over $1 million. After Zoernack stated his intent to repay an initial withdrawal, Zoernack continued to make withdrawals (without making repayments) that Apex repeatedly treated as “receivables,” rather than withdrawals by Zoernack, in the Net Asset Value (“NAV”) reports. Eventually, the “receivables” accounted for nearly 54% of the NAV of one fund and more than 26% of another fund. During this time, Apex learned that Zoernack had previously been convicted for wire fraud. According to the SEC, Apex repeatedly asked Zoernack to make disclosures about the withdrawals that he did not make. The SEC also found Apex ultimately determined that Zoernack would not be able to repay them. Nevertheless, Apex continued to report materially inaccurate NAVs. Release No. 4429.

ClearPath was charged with securities fraud violations relating to a misappropriation scheme last year in the District of Rhode Island. With respect to ClearPath, the SEC found Apex (i) “failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and inter-series and inter-fund transfers made in violation of the fund offering documents”; (ii) failed to correct prior financial reports and continued to issue “materially false reports and statements” to ClearPath and an independent auditor; and (iii) used those false reports in communication financial performance to investors. Release No. 4428.

Without admitting or denying the SEC’s findings, Apex agreed to retain an independent consultant to conduct a review of Apex’s policies and procedures and recommend corrective measures. Additionally, Apex will pay a total of $352,449, which includes (i) disgorgement of $89,050, plus $7,786 in interest and a $75,000 penalty for its actions with respect to EquityStar; and (ii) disgorgement of $96,800, plus $8,813 in interest and a $75,000 penalty for its actions with respect to ClearPath.

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