Month: April 2015

So It’s a Security, But Maybe the Private Placement Was Okay?

Looks like a great investment?
Looks like a great investment?

The tale of Western Financial Planning Corporation and Louis Schooler first caught my eye because the Securities and Exchange Commission brought charges against a real estate company. I stuck with the story because Western Financial tried really hard to structure the investments to avoid being considered securities. Even thought it tried really hard, a court still found that Western was selling securities. Having lost that battle, Western is staying on step ahead of the SEC charges. Western is claiming that the investments were sold through a good private placement.

Western had structured the real estate investment vehicles as general partnerships and sold those partnership interests to investors. The presumption is that a general partnership interest is not a security. So if the investments are not securities, then there can’t be securities fraud, and the Securities and Exchange Commission loses the case. Western lost the securities argument and the court found that the interests met the Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981)  three part operational test for an “investment contract” as a security.

Western would lose on the charge of selling an unregistered security unless it could find an exemption from registration. The firm argued that the sale of interests qualified for the exemption under Rule 506. Western managed to hold on a bit longer and managed to survive to continue the fight. The SEC failed to prove that the sale failed the Rule 506 tests.

The main parts of the Rule 506 exemption are:

  1. There must be no more than 35 purchasers who are non-accredited.
  2. The non-accredited investors must have the knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.
  3. The interests can not be offered for sale by general solicitation or general advertising (from Rule 502).

The first stumbling block is whether there was one long continuous sale of interests or merely several separate sales. 17 C.F.R. §230.502(a) sets out a five factor test for whether the separate sales should be “integrated” into one long continuous sale:

(a) Whether the sales are part of a single plan of financing;
(b) Whether the sales involve issuance of the same class of securities;
(c) Whether the sales have been made at or about the same time;
(d) Whether the same type of consideration is being received; and
(e) Whether the sales are made for the same general purpose.

Although Western sold 23 different properties and 86 general partnerships, the court found that they were sold close enough together to be integrated into one offering. Point to the SEC. As a result of losing that point, Western does not get up to 35 non-accredited investors for each general partnership, but only 35 against all of them.

The SEC made a mistake and had no evidence about the net worth of the investors. The SEC did not prove that there were more than 35 non-accredited investors. That leaves a dispute of material fact which means you don’t get summary judgment, but a trial instead.

The court draws an interesting distinction in general solicitation and notes the SEC’s no-action letter: E.F. Hutton&Co., No-Action Letter, 1985 SEC No- Act. LEXIS 2917 (Dec. 3,1985).  A general solicitation for clients does not turn into a general solicitation for securities as long as a “sufficient time” passes between establishment of the relationship and the offer.

Western argues that its extensive use of cold calls, networking groups, and mailings by an affiliate was merely to solicit clients for the affiliate and not to sell Western’s securities. The SEC failed to provide sufficient evidence that there was insufficient time.

Largely, this is matter of pleading and the SEC failing to put together the right evidence to win on summary judgement. The court is allowing the SEC to refile the motion and fix the evidence mistakes.

This just goes to the charge of selling unregistered securities. It’s not addressing any actual fraud by Western.

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Compliance Bricks and Mortar for April 10

brick plants

These are some of the compliance-related stories that recently caught my attention.

An Eerie Silence by David Kirk in McGuireWood’s The Fraud Board

There’s an eerie silence in the world of fraud prosecutions in the UK. A Libor trial is about to start, a FCA land banking prosecution is on trial at Southwark, but with reporting restrictions, and a couple of weeks ago David Dixon, author of a Ponzi Scheme, pleaded guilty; and Julian Rifat, having entered a guilty plea in the long-running Operation Tabernula case, was sentenced to 19 months in prison for insider dealing. But the City Slicker pages of Private Eye have not been full of critical comment about the ‘Serious Farce Office’ for some weeks – no doubt to the hearty relief of SFO Director, David Green QC – and apart from the odd reference to continuing enquiries, and the recent embarrassing fine by the Information Commissioner, there is indeed little to report in the Spring of 2015.

What to do When the CEO Vanishes? by Michael Volkov in Corruption, Crime & Compliance

CCOs face real challenges when the CCO does not have his or her star actor or actress to promote the company’s ethical culture. If you can imagine filming The Godfather without Marlon Brando, then you can imagine what a CCO must experience without the help or attention of the CEO.

Assuring Regulatory Compliance Doesn’t Get Lost in Translation by Christine Yi

It’s easy to get foreign language review wrong, and success depends on the right strategy, the right technology and the right aptitudes by those carrying it out.

SEC Brings First Action on Whistleblower ‘Pre-taliation’ by Bruce Carton in Compliance Week

The SEC has warned for some time now that it views companies’ attempts to potentially intimidate employees from coming forward as whistleblowers through confidentiality agreements as a form of retaliation — or “pre-taliation,” as the SEC’s Sean McKessy has dubbed it. McKessy, Chief of the SEC’s Office of the Whistleblower, stated last year that the SEC viewed such conduct as unlawful under the Dodd-Frank’s whistleblower rules, and that his office was “actively looking for examples of confidentiality agreements, separation agreements, [and] employee agreements” that condition benefits on not reporting activities to regulators such as the SEC.

Sure Fire Way To Spot a Fraud: Look for the SEC Seal

sec fraud

The Securities and Exchange Commission does not “approve” or “endorse” any particular securities, issuers, products, loans, services, professional credentials, firms or individuals. The SEC does not allow private entities to use its government seal. Yes, the staff of the SEC regularly meets with public companies, regulated entities, and others. Some of these investments and entities are required to be registered with the SEC.

But, the SEC never endorses an investment. Registration of a security does not imply its a good investment. Registration as an investment adviser does not mean you give good advice.

Investment advisers are required to include this statement on their Form ADV:

The information in this Brochure has not been approved or verified by the United States Securities and Exchange Commission or by any state securities authority. Registration as an investment adviser does not imply any level of skill or training.

Any claim – stated or implied – that the SEC has endorsed an investment is completely false. You are likely looking at part of a fraudulent scheme.

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Personal Foul Called on Athlete Lending Firm

referee-personalfoul

A professional athlete’s cash flow can be choppy. As an ex-NFL player, Will Allen knew about the cash flow problems. He also realized that fans could be lured into being lenders to professional athletes. It looks like Allen miscalculated the amount of investor interest against athletes looking for loans.

The Securities and Exchange Commission charged Mr. Allen with running a Ponzi scheme. According to the complaint, his firm paid $20 million to investors while only receiving $13 million in loan repayment proceeds. In all, Allen allegedly only made $18 million in loans while raising $31 million from investors.

Rumor has it that the SEC action is a fallout from the bankruptcy filing by NHL player Jack Johnson. The SEC complaint notes a purported $5.65 million loan to an NHL player, but filed only a $3.4 million loan in the bankruptcy filing. The SEC also claims that Allen and his firm lied to investors stating that the loan was still performing as expected. The firm also continued to make payouts to investors as if the loan was performing.

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The Producers Success and Oil Wells

oil well and compliance

In The Producers, Max Bialystock and Leo Bloom realize they can make more money with a flop than a hit. No one audits a flop and the fraudsters are free to flee with their investors’ money. According to the Securities and Exchange Commission, GC Resources, LLC and Brian J. Polito was trying to run a similar scam with oil and gas wells.

Polito was running a legitimate business for years, but then his wells were not producing much. He went out to a site and saw that several nearby wells owned by another company were very successful. Rather than alter his drilling strategy, he “adopted” those wells as his own. According to the SEC complaint, Polito forged documents showing GC Resource’s interests in the wells and began selling interests to investors.

The problem came that investors were expecting to get paid on those wells. Investors could look them up on the regulatory website and see that they were doing well. Polito was hoping for some dry wells so he could stop paying those investors. Just as Max and Leo were hoping that Springtime for Hitler would close on opening night.

To stem the cash outflow, Polito tried switching to quarterly payouts instead of monthly. An investor got angry at the change, sued and the litigation uncovered the deception.

So it seems the perfect fraud is a play that fails on opening night or a dry well. But if they keep producing the fraud will be revealed.

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Norman Leventhal

Norman Leventhal, the founder of my firm, passed away this weekend.

Norman LEVENTHAL map

Norman had a tremendous influence on Boston. His legacy will be with us for generations. He developed or re-develeped some of Greater Boston’s best-known landmarks: Rowes Wharf, Center Plaza, the Hotel Meridien, 75 State Street, and South Station. He formed the Norman B. Leventhal Map Center at the Boston Public Library, an extraordinary cartographic collection with over 200,000 historic and contemporary maps. The Norman B. Leventhal Park at Post Office Square is a 1.7-acre oasis in the Financial District’s granite, glass, and pavement desert that was formerly a hulking parking garage. He contributed years of service to MIT and Beth Israel Deaconess Medical Center,

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SEC Action for Stifling Whistleblowers in Confidentiality Agreements

whistleblower-info-promo

A story surfaced a few weeks ago that the Securities and Exchange Commission was taking a close look at employment agreements that limited the actions of whistleblowers. The story behind the story came out. The SEC brought an action against KBR, Inc. for violating whistleblower protection Rule 21F-17 enacted under the Dodd-Frank Act.

KBR required witnesses in certain internal investigations interviews to sign confidentiality statements with language warning that they could face discipline if they discussed the matters with outside parties without the prior approval of KBR’s legal department.  Since these investigations could have included allegations of possible securities law violations, the SEC found that these terms violated Rule 21F-17, which prohibits companies from taking any action to impede whistleblowers from reporting possible securities violations to the SEC.

The 2010 Dodd-Frank financial-reform bill granted a financial incentive for whistleblowers. A tipster can get between 10% and 30% of the penalty collected if their information leads to an SEC action. The whistleblower program handed out an award for more than $30 million last year that caught the attention of many.

The Dodd-Frank whistleblower regulations prohibit companies from interfering with employees reporting potential securities-law violations to the SEC. Rule 21F-17 provides in relevant part:

(a) No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.

The form confidentiality statement that KBR has used before and since the SEC adopted Rule 21F-17 requires witnesses to agree to the following provisions:

I understand that in order to protect the integrity of this review, I am prohibited from discussing any particulars regarding this interview and the subject matter discussed during the interview, without the prior authorization of the Law Department. I understand that the unauthorized disclosure of information may be grounds for disciplinary action up to and including termination of employment.

I bet many companies have a similar confidentiality provision.

The SEC brought the action even though it was not aware of any instances in which an employee was prevented from communicating the SEC about a potential securities law violation. Beyond that, the SEC was not aware of any instances in which KBR even tried to enforce the confidentiality provision.

KBR agreed to pay a $130,000 penalty to settle the SEC’s charges. The company voluntarily amended its confidentiality statement by adding the following language:

Nothing in this Confidentiality Statement prohibits me from reporting possible violations of federal law or regulation to any governmental agency or entity, including but not limited to the Department of Justice, the Securities and Exchange Commission, the Congress, and any agency Inspector General, or making other disclosures that are protected under the whistleblower provisions of federal law or regulation. I do not need the prior authorization of the Law Department to make any such reports or disclosures and I am not required to notify the company that I have made such reports or disclosures.

KBR also agreed to reach out to KBR employees subject to that confidentiality after August 21, 2011 (the date the rule was in effect) to say that the agreement does not prevent them from reaching out to the government to report possible violations.

KBR was the sacrifice to alert others to this potential problem. It seems harsh for KBR considering there is no statement of an incident where harm was done. I would assume that the confidentiality provision surfaced as part of some other government investigation of KBR.

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