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Archive for the ‘Securities Litigation and Financial Services’ Category

The S.E.C.’s Administrative Star Chamber Deemed Constitutional

Posted on: October 11th, 2016

judgeBy: John H. Goselin and Ze’eva Kushner Banks

If you are a broker-dealer, registered investment advisor or an individual associated with an entity regulated by the Securities and Exchange Commission (“S.E.C.”), the deck may be stacked against you. The Dodd-Frank Act provided the S.E.C. with expanded authority to utilize administrative proceedings presided over by administrative law judges selected by the S.E.C. to police the activities of entities and individuals regulated by the S.E.C.

In fiscal year 2015, administrative law judges issued 207 initial decisions and ordered civil penalties totaling $20,823,750 and disgorgement totaling $12,065,036 against industry individuals and entities. The administrative law judges are hired through the S.E.C.’s Office of Administrative Law Judges.  They issue decisions, which then get memorialized or altered by the Commission.  The S.E.C. sets the rules of procedure, the rules of discovery, and the scope of the proceedings in these administrative hearings.  And, of course, the S.E.C. picked the judges.

A number of individuals and companies in recent years have attempted to challenge the S.E.C.’s use of administrative law judges on a variety of grounds. Although due process and equal protection arguments generally have not been successful, there was some hope that relief from these administrative proceedings might be achieved through the argument that the S.E.C.’s appointment of its administrative law judges violates the Appointments Clause of Article II of the Constitution.  The Appointments Clause requires that the President has the ultimate authority to hire or fire government officials with executive authority.  Because the President neither appoints nor is able to directly fire these administrative judges, aggrieved parties have been arguing that the administrative law judges are executing unlawful executive powers.  The hope of undercutting these proceedings significantly dimmed with the recent decision by the U.S. Court of Appeals for the District of Columbia in Raymond James Lucia Cos. v. S.E.C. (No. 15-1345).

In Lucia, an appellate court, for the first time, considered the merits of the arguments regarding the constitutionality of the S.E.C.’s appointment of administrative law judges.  In one of these proceedings, a former investment advisor, Mr. Raymond Lucia, was barred for life from working in the securities industry and received an adverse judgment of $300,000 in monetary penalties and disgorgement.  Mr. Lucia followed the rules and exhausted his appellate options within the Commission before filing his case at the circuit court level.  The D.C. Circuit affirmed the Commission’s decision upholding the administrative law judge’s findings against Mr. Lucia, holding that because the S.E.C.’s administrative law judges do not have the power to issue final decisions, they fall below the threshold of authority required to be considered an officer for purposes of the Appointments Clause of the Constitution.  In short, the S.E.C. can legally appoint the judges.

When pursuing legal action against regulated individuals and/or entities, the S.E.C. has the choice to file civil charges for violations of the securities laws in either federal court or pursuant to its administrative proceedings. Regulated individuals and entities should be forewarned of the high likelihood that any such claims will end up in front of an administrative law judge hand-picked by the S.E.C.

Given that the odds of successfully challenging the constitutionality of these S.E.C. administrative courts has decreased drastically, it becomes even more important to have skilled counsel familiar with the process representing you if the S.E.C. knocks on your door.

Insider Trading Alert – It is Not Just a Wall Street Issue

Posted on: August 9th, 2016

one couple man and woman whispering at ear in studio silhouette isolated on white backgroundBy:  John Goselin and Ze’eva Kushner Banks

Be forewarned!  The Securities and Exchange Commission continues to hunt down individuals for improper insider trading.  Last week, the S.E.C. announced charges against Doctor Edward Kosinski for violations of the antifraud provisions of the federal securities laws by buying and selling shares of Regado Biosciences, Inc. (“Regado”) based on inside information.  And the regulator is not simply seeking disgorgement of ill-gotten gains.  The S.E.C. wants Doctor Kosinski to go to jail!!

Regado was a biotech company working on developing a drug called REG-1 to help regulate clotting in patients undergoing heart surgery.  Doctor Kosinski, a cardiologist, was also the president of Connecticut Clinical Research, LLC, and through this venture, Doctor Kosinski served as principal investigator of the drug trial of REG-1.  Doctor Kosinski had various contractual duties to keep any information he learned in connection with participating in the drug trial strictly confidential.  Doctor Kosinski, however, couldn’t resist the temptation to make multiple purchases of shares of Regado stock. Moreover, Doctor Kosinski failed to disclose his ownership in the company as required.  The value of Doctor Kosinski’s investment in Regado increased from approximately $34,090 in October 2013 to $250,800 by the end of May 2014.

June 29, 2014 was the beginning of the end for Doctor Kosinski.  Doctor Kosinski received important, undisclosed confidential information about Regado’s decision to put the REG-1 drug trial on hold due to serious allergic reactions suffered by some participants.  The very next day, Doctor Kosinski sold all of his shares in Regado for a profit.  When Regado ultimately made that same information public, the share price of Regado stock fell by 58%.  Consequently, Kosinski avoided a loss of approximately $160,000 by using his undisclosed, inside information to sell prior to the public announcement.

Nonetheless, Doctor Kosinski was not finished.  When he received additional undisclosed, confidential information a month later about the death of a participant in the drug trial, he bet that the price of Regado shares would drop further.  Just as before, after the company publicly released the information, its share price dropped drastically.  Doctor Kosinski’s bet against the stock price made him a profit of around $3,291.

The Securities and Exchange Commission has charged Doctor Kosinski with violating provisions of both the Securities Act of 1933 and the Securities Exchange Act of 1934.  Doctor Kosinski violated these antifraud provisions by trading in Regado’s stock based on confidential information that had not been made public.  The Securities and Exchange Commission is demanding that Doctor Kosinski return all the profits he made and/or the losses he avoided in addition to pay a penalty.  Doctor Kosinski could also find himself in jail.  Of course, Doctor Kosinski is also likely spending any profits he made to pay for his legal costs.

It is important to remember that professionals whether they are doctors, lawyers, accountants or just managers in a corporation can find themselves in possession of undisclosed confidential information about a publicly traded company.  You can receive this information through your business relationships, your personal friendships or even just chatting with the neighbors about how their summer may be going.  If you happen to learn important information, you need to be very cautious about buying or selling stock based in this confidential information.  In fact, you should not even consider buying or selling stock under these circumstances.  If you have any doubts, but feel compelled to make a purchase or a sale, you should really seek a second opinion.

Disclose! Disclose! Disclose! Says the S.E.C. to a Municipal Advisor

Posted on: March 28th, 2016

option 1By: John Goselin and Ze’eva Kushner Banks

Earlier this month, the Securities and Exchange Commission announced its first ever enforcement proceeding for breach of fiduciary duty for municipal advisors created by the Dodd-Frank Act of 2010. On March 15, 2016, the Securities and Exchange Commission publicized a settlement with Central States Capital Markets, LLC, its CEO and two employees arising from a failure to disclose a conflict of interest created by the role of Central States’ employees in providing both municipal advisor services and underwriting services for the municipal entity client.

The problematic arrangement started when Central States was hired by a city as its municipal advisor. Central States then arranged for the City’s offerings to be underwritten by a broker-dealer.  However, rather than engage in a negotiation or bidding process to secure the services of a non-conflicted broker-dealer, Central States unilaterally selected the broker-dealer at which Central States’ CEO and two employees were still working as registered representatives.  This arrangement resulted in Central States receiving from the City not only $130,117 in municipal advisory fees but also 90% of the $121,530 paid by the City in underwriting fees, pursuant to an agreement between Central States and the Broker-Dealer.

The S.E.C. found Central States, its CEO and two employees failed to make three specific disclosures to the City: (i) the fact that certain Central State employees worked for the Broker-Dealer; (ii) the fact that certain Central State employees were engaged in dual roles by performing both municipal advisor services and underwriting services for the City’s offerings; and (iii) these Central States employees had a conflict of interest due to their direct financial benefit from the underwriting services. The failure to make these disclosures constituted a breach of fiduciary duty.

Not only did they fail to disclose the conflict of interest as required under the Dodd-Frank Act, Central States and the individuals also violated Municipal Securities Rulemaking Board Rule G-17, which prohibits municipal advisors from engaging in any “deceptive, dishonest or unfair practice.” Meanwhile the individuals violated Rule G-23 as well, which prohibits brokers from acting as advisors on municipal securities they are underwriting. According to the settlement, Central States is paying a total of $374,827.8, and the three individuals are separately paying civil penalties ranging from $25,000 to $17,500.

Under the Dodd-Frank Act, municipal advisors, such as Central States, have a duty to put their clients’ interests ahead of their own. As stated by the S.E.C. in its press release, “[a]s fiduciaries, municipal advisors must identify and address all material conflicts of interest by eliminating or disclosing such conflicts.  Municipal entities rely on the advice of their municipal advisors and must feel confident that those advisors are working in the municipal entity’s best interests.”

The moral of the story is that municipal advisors are not immune from enforcement of the fiduciary duty provisions of the Dodd-Frank Act. As stated in an earlier post in the context of a conflict of interest stemming from outside business activities, the best practice is to err on the side of disclosure when there is any potential for a conflict of interest.




S.E.C. Smacks CFO and CAO for Inadequate Internal Controls

Posted on: March 23rd, 2016

option 1By: John Goselin and Ze’eva Kushner Banks

On March 10, 2016, the Securities and Exchange Commission announced a settlement with Texas-based oil company Magnum Hunter Resources Corporation, its former chief financial officer and its former chief accounting officer arising from a failure to properly evaluate and maintain internal control over financial reporting for more than a year and a half. Pursuant to the settlement, Magnum is paying a penalty of $250,000 subject to bankruptcy court approval, and the chief financial officer and former chief accounting officer are individually paying $25,000 and $15,000, respectively.

At the heart of the matter is a failure to identify staffing problems in the oil company’s accounting department, following four major acquisitions, as a material weakness that should be disclosed to the public.  Although the company’s consultant and audit engagement partner had raised red flags about the staffing problems, the former CFO and CAO applied the wrong standard when determining the severity of this control deficiency.  The executives based their decision on the lack of an actual error in the company’s financial reporting resulting from the staffing issue while they should have been considering whether there was a reasonable possibility that a material misstatement in the company’s financial reports would not have been detected in a timely manner.

Back in 2007, the Securities and Exchange Commission put out guidance on internal controls over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002. The underlying objective of internal controls over financial reporting is to provide the public with reasonable assurance that the financial reporting of the company is reliable.  Every year, a company’s management must evaluate and report on the effectiveness of the internal controls over financial reporting.   The S.E.C’s Order demonstrates that the S.E.C continues to monitor and value the importance of effective internal controls over financial reporting.  Moreover, the Order against Magnum’s chief financial officer and chief accounting officer cautions such high level accounting executives to rigorously assess internal controls to avoid sanctions.

Can You Hear (or See) Me Now? No, and that May Constitute Spoliation

Posted on: February 24th, 2016

Digital business voice recorder

By: Andy Treese

The Georgia Court of Appeals recently held that a municipality may be subject to sanctions for failure to preserve audio recordings of a police pursuit when the recordings were destroyed in the ordinary course of business before it received ante litem notice or other actual notice of contemplated litigation.

Last year we reported here about Phillips v. Harmon, in which the Supreme Court of Georgia held that the duty to preserve evidence may be triggered by a party’s constructive notice of pending or contemplated litigation.  The ruling marked a significant expansion from the previous rule, which required actual notice (such as a spoliation letter, letter of representation or ante litem notice) to trigger the duty.  We expressed concern that in the wake of Phillips, plaintiffs would begin to seek sanctions for spoliation based upon failure to preserve evidence when a defendant “should have” known a lawsuit was coming, and that defendants with relatively short record retention periods for audio or video recordings would be particularly vulnerable to these claims.   A recent ruling by a full panel of the Georgia Court of Appeals seems to validate those concerns.

In Loehle v. Georgia Department of Public Safety, 334 Ga. App. 836 (2015), plaintiffs filed suit against the Georgia Department of Public Safety and the City of Atlanta after they were injured by suspected carjackers fleeing from police. According to the opinion, Atlanta failed to preserve audio recordings related to the pursuit, destroying them pursuant to its customary retention period after about 120 days, prior to the receipt of ante litem notice.  The trial court held, applying pre-Phillips law, that Atlanta’s failure to preserve the recordings did not constitute spoliation because when the recording were destroyed, the city lacked actual notice that the plaintiffs were contemplating suit.  The Georgia Court of Appeals held, 6-1, that the trial court applied the wrong legal standard, vacated the trial court’s ruling as to spoliation, and remanded for re-consideration under the standard set forth in Phillips.  The sole dissenter, Judge Andrews, would have affirmed the trial court’s ruling because the plaintiffs did not make or preserve “constructive notice” arguments as to the spoliation issue before filing their appeal.

Strategically, the Loehle ruling emphasizes the importance of prompt and thorough investigation of potential claims, even in the absence of a preservation request. Companies with relatively short retention policies (30, 60, or 90 days), particularly regarding audio and video-recordings, may want to re-examine their current policies and consider involving counsel early in pre-suit investigations.

A petition for certiorari has been filed to the Supreme Court of Georgia; we will monitor the case and report on future developments.