Category Archives: Securities Fraud

Auditing the Auditor: SEC Charges Firm With Inadequate Surprise Exams

On April 29, 2016, the SEC brought and settled charges that an accounting firm, Santos, Postal & Co. (“Santos”) and one of its principals, Joseph Scolaro (“Scolaro”), performed inadequate surprise exams of one of their investment advisor clients, SFX Financial (“SFX”), the president of which stole over $670k from SPX clients. Santos and Scolaro neither admitted nor denied the allegations in the SEC Order but consented to its entry and to disgorgement and penalties totaling over $55,000. Santos and SColaro agreed to be suspended from practicing before the SEC, which includes preparing financial reports and audits of public companies. Santos and Scolaro are permitted to apply for reinstatement after one and five years, respectively.

Because SFX was deemed to have custody of client assets under SEC Rule 206(4)-2 (the “Custody Rule”), SFX was required to hire an independent accountant (Santos) to perform surprise audits. The Custody Rule seeks to protect clients from asset misappropriation by investment advisors (e.g., Ponzi schemes). Accordingly, among other things, Santos was supposed to contact SFX’s clients to verify that they were aware of the contributions and withdrawals into and out of their accounts as reflected in SPX’s records. According to the SEC Order, Santos failed to actually contact clients about such transactions.

The SEC previously announced charges against SFX’s president Brian Ourand, who was later found by an administrative judge to have misappropriated funds from client accounts in violation of the Investment Advisers Act of 1940. Ourand was ordered to pay disgorgement of $671,367 plus prejudgment interest and a $300,000 penalty, and was barred from the industry. SFX and its CCO separately agreed to settlements.

The SEC’s Order relating to Santos and Scolaro can be found here:

https://www.sec.gov/litigation/admin/2016/34-77745.pdf

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SEC: Ski Resort Operators Abused Immigrant Investor Program (EB-5)

The SEC recently announced it would pursue fraud charges and freeze the assets of the Jay Peak, Inc. Vermont ski resort. The SEC alleges that Ariel Quiros, of Miami, and William Stenger, of Vermont, conducted an illegal Ponzi-like scheme in connection with the funds raised for the resort. The total amount of money in question with these activities is $350 million, a large portion of which was raised through the EB-5 Immigrant Investor Program, a program designed to incentivize foreign investment by promising a fast track to a green card.

According to the SEC, Quiros and Stenger diverted money from the ski resort project to other projects in an attempt to finance them. In addition, an alleged $50 million was spent on Quiros’s personal expenses, such as his personal income taxes and a luxury condominium. There appears to be little money left to fund the ski resort renovations.

Further, the actions of Quiros and Stenger could put many investors’ funds and immigration petitions in jeopardy. In order to get their green card the investors need to fund at least 10 new jobs, which may not happen here.

Given these charges, it is unclear whether investors who were considering committing capital to U.S. projects under EB-5 will still do so. It is also unclear as to whether this is a continuing problem or isolated incident.

Here’s the link to the SEC news release.  https://www.sec.gov/news/pressrelease/2016-69.html

 

SEC Sues R.I. Agency and Wells Fargo Claiming They Misled Investors in Curt Schilling’s Video Game Company

The SEC has sued the Rhode Island Economic Development Corporation (RIEDC) and bond underwriter Wells Fargo alleging that RIEDC and Wells Fargo misled bond investors in connection with their investments in Curt Schilling’s failed video game company, 38 Studios. RIEDC had lured 38 Studios to Rhode Island with significant incentives, including the bond deal, only for 38 Studios to fail.

According to the SEC, investors, who poured $75 million into 38 Studios, were not told that it needed substantially more money to produce a video game. In addition, Wells Fargo allegedly failed to disclose that it had a side deal with 38 Studios, which presented a potential conflict of interest. When the company went belly up, the investors were left with the bag. Although neither Schilling nor his company is accused of any wrongdoing in the SEC action, they have been sued civilly.

Municipal finance deals face increased SEC scrutiny. This applies to issuers and underwriters. As SEC Director of Enforcement Andrew Ceresney has stated, “[m]unicipal issuers and underwriters must provide investors with a clear-eyed view of the risks involved in an economic development project being financed through bond offerings.”

SEC Awards Whistleblower-Executive A Half-Million Dollars For “Reporting Out.”

The SEC has doled out over $50 million in awards to 15 individuals since it inaugurated the Dodd-Frank mandated whistleblower program 3 years ago. That program permits whistleblower awards of 10% to 30% of the total money recovered from a securities law violator provided the sanctions exceed $1 million. Whistleblower awards are usually restricted to individuals who provide original information derived from their independent knowledge or analyses. Failure to be deemed an “original” source of information is ordinarily the end of a whistleblower claim.

On March 2, 2015, however, the SEC approved an award of $475,000 to $575,000 to an unnamed executive who merely passed along original information.[1] That award stemmed from a special carve-out designed to incentivize officers and directors to report out where the company fails to take corrective action. Specifically, an executive may be entitled to a whistleblower award if he or she reports information to the SEC 120 days after alerting upper management of the problem. Similarly, if upper management is already aware of the problem at the time the executive learns of it, the executive-whistleblower must wait 120 days before reporting to the SEC.

The rationale for the 120-day rule is two-fold. On the one hand, the SEC wants to protect companies that have robust compliance programs in place and a strong compliance tone from the top. After all, companies who invest in compliance programs and take potential violations seriously should be afforded a safe harbor whereby they are protected from individuals hoping to make a quick buck by passing information along before the 120-day period expires.

On the other hand, the SEC realizes that executives and directors are uniquely placed to take action when upper management will not remedy the problem. Executives regularly receive management and compliance reports and are often the first persons to whom an employee will turn to report an issue. The SEC wants to incentivize such executives to step forward when upper management refuses to take corrective action.

However, an executive considering becoming a whistleblower risks significant reputational and financial harm. Although the whistleblower process is anonymous, upper management at the company may be able to figure out who reported out and may take retaliatory action against that individual.   Or, the individual may have already resigned due to irreconcilable differences with the company. In either case, there is no guarantee of a whistleblower award. Accordingly, executives and directors thinking about “reporting out” should carefully consider the quality of the information they possess and the potential financial and reputational risks.

[1] https://www.sec.gov/news/pressrelease/2015-45.html#.VP79EIHF87M

Fifth Time’s A Charm – A Series Of Corporate Disclosures, Together, Can Be A “Corrective Disclosure.”

On October 2, 2014, a federal appeals court revived an investor class action that had been dismissed by the trial court for failure to plead loss causation. The case is Public Employees Ret. Sys. of Mississippi v. Amedisys, Inc., 13-30580 (5th Cir. Oct. 2, 2014).[1] In it, the Court found that a series of partial disclosures could collectively constitute a “corrective disclosure” of the defendant’s misrepresentations, which the plaintiffs plausibly alleged caused a decline in the defendant’s stock price.

The plaintiffs filed a complaint against Amedisys, a home health care services provider, and certain executives alleging that the company issued false and misleading public statements that concealed its fraudulent Medicare billing practices and artificially inflated its stock price between 2005 to 2010. The complaint alleged that a series of five “partial disclosures,” spread over two years, revealed the misrepresentations and caused a decline in the stock price, as the truth became known.

The disclosures, which spanned from August 2008 to September 2010, included two news reports questioning Amedisys’s billing practices; a press release announcing the resignation of its CEO and CIO; announcements of investigations into the company by the Senate Finance Committee, the SEC, and the DOJ; and the announcement of disappointing operating results in the second quarter of 2010. During the same time period, Amedisys’s stock price gradually declined from $66.07 to $24.02, a drop of over 60%.

The district court analyzed each of the disclosures separately and found that none of them constituted a “corrective disclosure,” which exposed the falsity of Amedisys’s prior statements. The district court dismissed the complaint with prejudice for failure to adequately plead that the plaintiffs’ losses were caused by the company’s misrepresentations.

The Fifth Circuit, however, found that a corrective disclosure does not have to be a single disclosure and analyzed the five disclosures in the Complaint “collectively.” The Court admitted that, if taken alone, the individual disclosures did not make the existence of fraud more probable, noting that neither media speculation concerning wrongdoing nor the mere commencement of a government investigation constitute a corrective disclosure of fraud. Nevertheless, the Court ruled that when taken together, the entire series of events plausibly indicated that the market “was once unaware of Amedisys’s alleged Medicare fraud, had become aware of the fraud and incorporated that information into the price of Amedisys’s stock.” Importantly, the Court noted that the Complaint linked each of the partial disclosures to a corresponding drop in stock value. Accordingly, the Court held that the plaintiffs adequately pled that Amedisys’s alleged false statements caused their loss and reversed the district court’s dismissal.

[1] http://www.ca5.uscourts.gov/opinions%5Cpub%5C13/13-30580-CV0.pdf

Federal Judge Reminds Plaintiff Investors That Securities Laws Are Not Broad Insurance Against Market Losses

On September 30, a federal judge dismissed a putative class action against New Energy Systems (“New Energy”), a lithium battery company with Chinese operations, finding that plaintiffs had failed to connect the dots between the alleged misrepresentation (overstated earnings) and any drop in stock price when the “fraud” was revealed.[1] Because there was no material change in stock price when New Energy amended its SEC filings thereby “revealing” the company’s problems, the plaintiffs attempted to tie their losses to an earnings press release, issued 8 months after the amended filings. The Court flatly rejected this later, “materialization of concealed risk” theory.

The Complaint focused on income discrepancies between New Energy’s 2008-2009 filings with the SEC and its filings with the Chinese equivalent of the SEC. Plaintiffs alleged that the revenue and earnings numbers in the SEC filings were hundreds and sometimes thousands of percentage points higher than the numbers in the Chinese filings. Both sets of numbers were publicly available to investors.[2]

Then, in March 2011, New Energy amended its Chinese filings such that they conformed to the higher numbers in its SEC filings. The market had no reaction whatsoever to the amended filings. In November 2011, however, New Energy issued a press release announcing a 42% decline in year-over-year revenues for the third quarter of 2011. The stock dropped 48.6%.[3]

Plaintiffs argued that the late 2011 drop after the press release was connected to an ongoing fraud dating back to 2008 and that New Energy had merely covered up past problems by moving such losses into its late 2011 numbers, rather than coming forth and admitting that the 2008-2009 amended filings were false. The Court rejected this late “materialization of concealed risk” as too tenuous, finding no link between the loss in late 2011 and the alleged misstatements about income for 2008-2009. Among other things, the Court noted that, “private securities fraud actions are available not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause.”[4]

Importantly, it does not appear that the Court completely shut the door – the Order does not state the complaint is dismissed with prejudice. It may be that the plaintiffs can try to amend or re-file with sufficient allegations to better tie the November 2011 “corrective disclosure” to a particular fraud. But the message is clear, would-be plaintiffs must allege facts sufficient to show that their losses are at least “within the zone of risk concealed by the misrepresentations and omissions” about which the plaintiff complains.

[1] In re: New Energy Systems Securities Litig., 12-cv-01041 (LAK), Dkt. No. 49 (S.D.N.Y. Sept. 30, 2014).

[2] See id. at 3-4.

[3] See id. at 4.

[4] See id. at 7.