This Week In Securities Litigation

by Dorsey & Whitney LLP

The SEC prevailed in one court case this week but lost in another. In an investment fund fraud action the agency won at trial. In the First Circuit, however, it lost in an appeal of the long running action against two former State Street Bank executives.

Broken windows continued this week with the filing of fourteen administrative proceedings. Seven were against either audit firms or individual accounts, suspending them from practice before the Commission for failures and misconduct in connection with audits. Seven were against either lawyers or their firm for acting as unregistered brokers in connection with EB-5 programs.


Remarks: Chair Mary Jo White delivered the Keynote Address at the 2015 AICPA National Conference, titled “Maintaining High-Quality, Reliable Financial Reporting: A Shared and Weighty Responsibility,” Washington, D.C. (Dec. 9, 2015). Her remarks discussed the responsibility of auditors and audit committees as well as standard setters and regulators (here).


Testimony: Chairman Timothy G. Massard testified before the House Committee on Financial Services (Dec. 8, 2015). His testimony focused on the agenda, structure and operations of the Financial Stability Oversight Council (here).

SEC Enforcement – Litigated Actions

Investment fund fraud: SEC v. National Note of Utah, Civil Action No. 2:12-cv-00591 (D. Utah). Defendant National Note is one of a complex of entities controlled by Wayne Palmer, also a defendant in the action. Investors were solicited in two offerings. Prior to 2007 an offering of unregistered notes was conducted. It raised about $50 million. Beginning in September 2007 a private placement of notes under Rule 506 of Regulation D raised another $50 million. Some of the investors were accredited, some were not. Generally, investors were solicited to purchase notes of National Note. Investors were told that the notes would pay 12% interest and that they were secured by the real estate holdings of several related entities. Investor funds were supposedly loaned to the related entities for investment. The interest payments were guaranteed, according to the sales pitch. Investor funds were supposedly secured by interests in real estate. Some investors were provided with glossy marketing materials which largely reiterated these claims. They were false. In fact investors were being paid from funds received from others. By 2011 National Note had difficulty raising additional capital. Payments to investors dwindled. While promises of repayment were made, the payments were not made. The SEC’s complaint alleged violations of Securities Act Sections 5(a), 5(c) and each subsection of 17(a), in addition to violations of Exchange Act Sections 10(b) and 15(a). A temporary freeze order was obtained by the Commission at the time of filing.

Following a trial the court found in favor of the SEC. The court concluded Mr. Palmer had promised over 600 investors a guaranteed return of 12% while assuring them that their funds were safe. The Court also found that he had deposited investor funds in one account titled “investor trust account,” wired the funds to a second tilted “investor interest account,” and made payments of returns from the funds of other investors. The Court ordered Mr. Palmer to pay disgorgement of $1,767,287.10. National Note was directed to pay disgorgement of $65,188,83. Mr. Palmer was also ordered to pay a penalty of $1,050,000 while National Note will pay $900,000. See Lit. Rel. No. 23419 (December 4, 2015).

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 2 civil injunctive cases and 14 administrative proceeding, excluding 12j and tag-along proceedings.

Auditing: In the Matter of Peter Messineo, CPA, Adm. Proc. File No. 3721 (Dec. 10, 2015) is one of seven actions involving five accountants and two audit firms, each of which was suspended from appearing or practicing before the SEC as accountants for, at various times, performing deficient audits of public companies, jeopardizing the independence of other audits and falsifying and backdating audit documents.

Offering fraud: In re Covenant Partners, L.P., Bankruptcy No. 14-17568 (E.D. Pa.) is a an action previously brought as an administrative proceeding against Covenant Partners, L.P., William Fretz, John Freeman and unregistered investment adviser Covenant Capital Management Partners, L.P. The action centered on the sale of interests through the adviser in a private equity fund. Rather than invest the funds Respondents diverted the funds to their personal use. In resolving the case the investment fund, jointly and severally with the other Respondents, will owe the SEC about $5.8 million which will be distributed to harmed investors. See Lit. Rel. No. 23423 (Dec. 8, 2015).

Fraud: SEC v. Skilling, Civil Action No. 4-00284 (S.D. TX.) is an action against former Enron president and COO Jeffrey Skilling. The Commission concluded its case against Mr. Skilling, obtaining a judgment based on collateral estoppel tied to his criminal conviction and non-opposition to the motion. The judgment is based on violations of Exchange Act Sections 10(b) and 13(b)-5. The court also entered a permanent officer and director bar. See Lit. Rel. No. 23422 (Dec. 8, 2015).

Pyramid scheme: SEC v. Gilmond, Civil Action No. 3:15-cv-00591 (W.D.N.C. Filed December 4, 2015). This action names as a defendant Trudy Gilmond and centers on ZeeksRewards which traces to 2010 when Paul Burks and others created as a penny auction website. While not that successful, Mr. Burks and his company, Rex Venture Group, LLC, and others launched ZeekRewards in January 2011. The new program was a private, invitation only affiliate advertising division of Zeekler. It was a multi-level marketing program that offered subscription memberships to affiliates. Those recruited then brought in other new affiliates and purchased and gave away samples or sold packages of bids for the penny auction website. Ms. Gilmond was a network marketer who participated in a number of multi-level marketing programs. She operated a full time business soliciting new affiliates and helping her recruits solicit others. No effort was made to determine the financial wherewithal to invest, or the experience level of, customers. Over a period of about one and a half years, beginning in January 2011, the firm raised about $850 million through the offer and sale of securities through the Retail Profit Pool and the Matrix to approximately one million domestic and international investors. In fact ZeeksRewards was as a fraudulent scheme. The average 1.5% daily dividend to Qualified Affiliates was selected to sustain the false impression that the business had returns of 125% every 90 days. Profits from the penny auctions were miniscule and the daily awards could only be supported by funds from others. From her efforts Ms. Gilmond received $461,964 in Matrix commissions and $1,300,074 in daily dividend payments and bonuses based on her purchases and compounding payments in the Retail Profits Pool. Although ZeeksRewards paid out hundreds of millions of dollars, by July 2012 it had insufficient deposits to satisfy future awards. The scheme was thus nearing collapse by the time it was shut down in August 2012. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 15(a). The case is pending. See Lit. Rel. No. 23421 (December 8, 2015).

Offering fraud: SEC v. Feng, Civil Action No. 2:15-cv-09420 (C.D. CA. Filed December 7, 2015). The defendants in the action are attorney Hui Feng and his firm, Law Offices of Feng & Associates P.C. Defendants began promoting the EB-5 program in 2010. Typically, Mr. Feng wrote retainer agreements with clients requiring the payment of legal fees. Defendants recommended clients invest in the offerings of at least five different EB-5 promoters. Commissions were paid by the promoters that ranged from $15,000 to $70,000 per transaction. In addition, if the clients petition was approved the firm was paid additional compensation. Neither Mr. Feng nor his firm disclosed to their clients that they were paid commissions from the promoters. Likewise, the conflict of interest this presented was not disclosed, although if clients specifically inquired they were told. Beginning in May 2013 some promoters told Mr. Feng that they would not wire commissions to a U.S. bank, apparently to avoid the prospect of unregistered broker issues. Mr. Feng circumvented this prohibition by using nominees to whom the payments were made but who secretly acted on his behalf. The representations to the promoters were thus materially false. From March 2011 through April 2015 Defendants or their nominees received at least $1.1 million in commissions from the five promoters and are owed additional fees. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). The action is pending. See, e.g., In the Matter of Kefei Wang, Adm. Proc. File No. 3-16987 (December 7, 2015)(This is one of seven Section 15(a) actions settled by an attorney or the firm in which the attorney effectuated transactions in EB-5 securities, acting as a liaison between the program investment officers and investors and received transaction based compensation; settled with a cease and desist order and the payment of disgorgement and prejudgment interest).

Circuit courts

Flannery v. SEC, Nos. 15-1080 & 15-1117 (1st Cir. December 8, 2015) is an action brought against former State Street Bank and Trust Company employees John Flannery, formerly the chief investment officer, and James Hopkins, formerly the vice president and head of North American Product Engineering. The Order alleged violations of Exchange Act Section 10(b) and Securities Act Section 17(a). It centered a series of claimed false statements made by the two men that supposedly mislead investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management. As a result of those false and misleading statements investors continued to purchase shares in the funds or maintain their positions as the market crisis unfolded and the sub-prime market unraveled. Following a hearing the ALJ dismissed all the charges. The Commission reversed in a 3-2 decision, finding that Mr. Flannery violated Section 17(a)(3) since he was responsible for two misleading letters. The agency also concluded that Mr. Hopkins violated both sections cited in the Order because he was responsible for one false slide that had not been updated in a deck of 20 used in client presentations.

The circuit court reversed, concluding that the SEC’s decision was not supported by substantial evidence as required by the APA. The materiality of the misstatements on the slide – the court assumed for this decision that it was false – was marginal at best, thus belying a finding of scienter. One of the two letters the SEC alleges were false as to Mr. Hopkins had been misread by the agency, and in any event, at oral argument counsel admitted that it did not contain false statements.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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