Securities Law Archives - Page 13 of 26

Multi-Level Tipping: Insider Trading Cartoon Series, Vol. XI [VIDEO]

In this Presidential transition season, we bring you a very special episode of the Insider Trading Cartoon Series.

David Smyth has a wide-ranging enforcement and litigation practice that focuses on representation of individuals and corporations facing action by federal and state authorities.

ARTICLE BY David Smyth of Brooks, Pierce, McLendon, Humphrey & Leonard, LLP

Part 1 – The Insider Trading Cartoon Series Vol. I — Classical Theory

Part 2 – Insider Trading Cartoon Series, Vol. II — Temporary Insiders

Part 3 – The Insider Trading Cartoon Series, Vol. III — Very Temporary Insiders

Part 4 – Insider Trading Cartoon Series, Vol. IV — Rank-and-File Employees [VIDEO]

Part 5 – Insider Trading Cartoon Series, Vol. V — Misappropriation Theory [VIDEO]

Part 6 – Insider Trading Cartoon Series, Vol. VI — Misappropriation (Part Deux) [VIDEO]

Part 7 – Insider Trading Cartoon Series, Vol. VII — Misappropriation Theory (Part the Third)

Part 8 – Negligence Based Charges – The Insider Trading Cartoon Series, Vol. VIII [VIDEO]

Part 9 – Tender Offers – The Insider Trading Cartoon Series, Vol. IX [VIDEO]

Part 10 – Tipping (Pre-Newman): Insider Trading Cartoon Series, Vol. X

Salman Decision: Supreme Court Weighs in on Insider Trading

Significant decision comes after nearly two decades of silence. For the first time in nearly 20 years, the US Supreme Court has weighed in on insider trading law and handed a victory to the government and its insider trading enforcement efforts. In Salman v. United States,^[1] the Court put to bed confusion generated by the US Court of Appeals for the Second Circuit’s decision in United States v. Newman.^[2] In Newman, the Second Circuit held that to be guilty of insider trading, (i) a tippee must know that the insider/tipper breached a duty of confidentiality in exchange for a “personal benefit” and (ii) the personal benefit must be an “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similar valuable nature.”

The second part of this holding posed more questions than it answered because it appeared to conflict with the Supreme Court’s 1983 decision in Dirks v. SEC.^[3] The Court in Dirks found that an insider/tipper may be liable for insider trading, and a tippee derivative liable, only if the insider disclosed confidential information in exchange for a personal benefit. And this “personal benefit,” Dirks found, can be shown when an insider “makes a gift of confidential information to a trading relative or friend.” But in 2014, Newman injected a pecuniary-gain element into the personal-benefit test, leaving the government and defense counsel to wonder what is required when a tipper gifts information to a relative or friend who then trades on the information. As discussed below, Salman has dispelled this confusion by following Dirks in holding that an insider’s gift of confidential information to a trading relative is a sufficient personal benefit.

The Newman Case

In Newman, defendants Todd Newman and Anthony Chiasson were “remote” or “downstream” tippees charged with trading on material nonpublic information (MNPI) that they received from other tippees concerning earnings information at two prominent technology companies.

At trial, Newman and Chiasson urged the court to adopt jury instructions that predicated guilt upon a showing that they knew the insiders tipped the MNPI in exchange for a personal benefit. US District Judge Richard J. Sullivan found that although such an instruction could be supported by Dirks, he was obliged to follow the Second Circuit’s decision in SEC v. Obus,^[4] which, arguably, only required a showing that the tippee knew of a tipper’s breach of duty to establish scienter.^[5] Newman and Chiasson were convicted at trial.

On appeal, the Second Circuit reversed both convictions. The court held that a tippee only knows of the tipper’s breach of fiduciary duty if “he knew the information was confidential and divulged for personal benefit.”^[6] In other words, the court agreed with defendants that knowledge of a tipper’s breach of fiduciary duty required knowledge that the confidential tip was made in exchange for a personal benefit.^[7] But the court further held that a personal benefit cannot be inferred “by the mere fact of a friendship”; rather, it must be established through “proof of a meaningfully close relationship that generates an exchange that is objective, consequential, and that represents at least a potential gain of a pecuniary or similarly valuable nature.”^[8] The government appealed the Second Circuit’s decision, but the Supreme Court declined to hear the case.

The Salman Case

In the summer of 2015, the US Court of Appeals for the Ninth Circuit decided United States v. Salman,^[9] in which defendant Bassam Yacoub Salman, a remote tippee, had received and traded on MNPI from his brother-in-law Michael Kara, who in turn had obtained the information from his older brother Maher Kara, an investment banker at a large bank. Evidence showed that Salman was aware that the MNPI originated with Maher, and that from 2004 to 2007, Salman and Michael had profited from trading in securities issued by the bank’s clients just before major transactions were announced, but there was no evidence that Maher received any pecuniary benefit for his tips. Salman was convicted at trial.

On appeal, Salman argued that under Newman, the evidence was insufficient to show that Maher had tipped the information to his brother in exchange for a pecuniary benefit or that Salman knew of any such benefit. The court dismissed this argument as a strained misreading of Newman, holding that Newman did not seek to undermine Dirks’s crucial observation that a tipper may obtain a personal benefit when (s)he “makes a gift of confidential information to a trading relative or friend.” Otherwise, as the court noted, “a corporate insider . . . would be free to disclose [MNPI] to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return.” Notably, the Ninth Circuit held that Newman’s personal-benefit language must be interpreted in a narrower way than others might attempt to use it, and that to the extent Newman cannot be interpreted so narrowly, the Ninth Circuit would “decline to follow it.”^[10] Salman appealed the Ninth Circuit’s holding, and the Supreme Court granted certiorari.

The Supreme Court’s Decision

In Salman v. United States,^[11] the Court unanimously affirmed the Ninth Circuit’s holding. The Court squarely rejected Salman’s argument that an insider must receive a pecuniary quid pro quo from a tippee for there to be a sufficient personal benefit. The Court found that Dirks made clear that a tipper breaches a fiduciary duty—and receives a personal benefit—by making a gift of confidential information to a “trading relative or friend,” which clearly happened in this case. Notably, the Court declined to adopt the government’s broader argument that “a tipper personally benefits whenever the tipper discloses confidential trading information for a noncorporate purpose.”^[12] Rather, the Court found that Dirks “easily resolves the narrow issue presented here.”^[13] In applying Dirks, the Court found that “Maher, a tipper, provided inside information to a close relative, his brother Michael. Dirks makes clear that a tipper breaches a fiduciary duty by making a gift of confidential information to ‘a trading relative,’ and that rule is sufficient to resolve the case at hand.”^[14]

Regarding the Second Circuit’s holding in Newman, the Court found that “[t]o the extent the Second Circuit held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends, Newman, 773 F.3d, at 452, we agree with the Ninth Circuit that this requirement is inconsistent with Dirks.”^[15] The Court held that Salman’s jury was properly instructed that a personal benefit includes the benefit one would obtain from simply making a gift of confidential information to a trading relative, and, accordingly, upheld the Ninth Circuit’s judgment.

The Supreme Court’s decision is extremely significant. Salman resolves confusion raised by Newman by specifically rejecting—as inconsistent with Dirks—the Second Circuit’s requirement that the tipper must receive something of a “pecuniary or similarly valuable nature” in exchange for the information and that a gift to family or friends was insufficient. In so doing, and on the issue of what constitutes a “personal benefit,” the Salman decision essentially turns back the clock on the law of tipper liability to its status pre-Newman, which had partially derailed the government’s insider trading enforcement efforts. Thus, it appears that Salman is a boon to the government’s ability to get its insider trading efforts back on track.

ARTICLE BY David I. Miller, Nathan J. Hochman, Kenneth I. Schacter, E. Andrew Southerling & Grant R. MacQueen of Morgan, Lewis & Bockius LLP

^{[1] 580 U.S. __ (2016).}

^{[2] 773 F.3d 438, 450 (2d Cir. 2014).}

^{[3] 463 U.S. 646 (1983).}

^{[4] 693 F.3d 276 (2d Cir. 2012).}

^{[5] See United States v. Newman, 1:12-cr-00121-RJS-2, Docket No. 215, pp. 3594-3605 (S.D.N.Y. Dec. 10, 2012).}

^{[6] 773 F.3d 438, 450 (2d Cir. 2014) (emphasis added).}

^{[7] Newman, 773 F.3d at 447-49 (“[W]e conclude that a tippee’s knowledge of the insider’s breach necessarily requires knowledge that the insider disclosed confidential information in exchange for personal benefit.”).}

^{[8] Id., 773 F.3d at 452.}

^{[9] 792 F.3d 1087 (9th Cir. 2015).}

^{[10] Id., 2015 WL 4068903 at *6.}

^{[11] 580 U.S. __ (2016).}

^{[12] Slip op., at 7.}

^{[13] Slip op., at 8.}

^{[14] Slip op., at 9.}

^{[15] Slip op., at 10.}

A New Regulatory Paradigm For The SEC Following the Election?

Many are speculating on the future of federal securities regulation as a result of the election of Donald J. Trump and the concomitant Republican control of both houses of Congress. Broc Romanek, for example, asks whether Michael S. Piwowar will become the SEC’s next Chairman. Broc notes that Commissioner Piwowar is an economist, not a lawyer. Since the SEC is concerned with financial regulation, a background in economics should be a strong plus.

Since I’ve already seen signs of holiday decorating in the stores, I’ve drawn up my own short wish list for whomever takes the helm of the SEC.

The SEC should fundamentally change its approach to evaluating regulations. When considering the adoption of any new substantive regulation, the fundamental question must always be “Why is this regulation necessary?” A regulation isn’t necessary simply because someone thinks it is a good idea or constitutes a perceived “best practice”. A regulation is necessary only when it can be demonstrated that there is some market impediment that can only be removed by government intervention. It seems that regulations are too often adopted in reverse. It is tantamount to a doctor, knowing that a drug has proved beneficial in some cases, prescribes it to her patients without first making a diagnosis. If a market impediment exists, then the regulatory effort should be directed at removing the impediment not imposing additional requirements.

The SEC should ask Congress to repeal Section 16(b) liability. When Congress enacted Section 16 more than four score years ago, it was recognized that it was a “crude rule of thumb”. Given the rapidity of modern trading, the arbitrary six month period seems positively quaint. The calculation of profits under the rule can be bizarre. In some cases, persons are liable even when they recognized no overall economic profit. Congress enacted the rule to deter insider trading, but many persons who are guilty of trading on the basis of material non-public information aren’t even subject to the rule. In practice, the rule has become an economic boon to a few lawyers and a technical trap for many. At eighty plus years, Section 16(b) has had a good run, but now is time for it to leave the stage.

The SEC should abandon and repudiate its attempts to co-opt attorneys. Attorneys are their clients’ advisers and advocates. They are not gatekeepers as the SEC has on occasion supposed. The SEC should amend its attorney conduct (Part 205) rules to eliminate the purported ability of lawyers to disclose client confidences to the SEC. See Conflicting Currents: The Obligation to Maintain Inviolate Client Confidences and the New SEC Attorney Conduct Rules, 32 Pep. L. Rev. 89 (2004) and this post. The SEC should also amend its whistleblower rules to eliminate the possibility of attorneys obtaining whistleblower awards. See SEC Condemns Breach Of Client Confidences While Offering Possible Bounties For Breaches.

Allow companies to pick their reporting periods. There has been much debate about whether publicly traded companies suffer from short-termism. Although short-termism may have multiple causes, the SEC’s rigid requirement of quarterly financial information pressures companies to focus on short-term results. Why not let companies pick their own reporting periods? This will allow companies to telegraph to the market whether they are focused on short-term or long-term performance. To those who say that this is a bad idea, I say why not let the market decide? If investors think that semi-annual or annual reporting is inadequate, then companies making those choices will be undervalued and will incur higher costs of capital. Some companies might even elect to report more frequently than every quarter (e.g., bi-monthly). The beauty of this approach is that it is transparent and allows the market to achieve equilibrium at the optimal time for each issuer.

Allow companies to decide whether they will be subject to routine SEC review. It is hard to assess the efficacy of SEC staff review of filings. I’m sure that the SEC believes that staff review improves disclosure and that may well be the case. One way to test that position, is to allow companies to elect whether to have their filings be subject to SEC staff review. These elections would be public. Investors could then decide whether SEC review reduces risk through enhanced disclosure (because companies will do a better job because they know they are subject to review and/or because the staff’s comments result in improved disclosure). The efficacy of review should be reflected in differences in the cost of capital.

Readers will note that repeal of the Dodd-Frank Act is not on my wish list. That is the subject of this blog by Cydney Posner at Cooley LLP. As a final note, this is my personal wish list and it does not necessarily represent the wish list of my firm, partners, or any my firm’s clients.

ARTICLE BY Keith Paul Bishop of Allen Matkins Leck Gamble Mallory & Natsis LLP

Nasdaq Makes Preparations to Shorten Settlement Cycle for Securities Transactions from T+3 to T+2

In connection with the industry-led initiative to shorten the settlement cycle for transactions in U.S. equities and other securities from trade date plus three business days (T+3) to trade date plus two business days (T+2), the Nasdaq Stock Market LLC (“Nasdaq”) has preliminarily identified certain rules that establish or reference a T+3 settlement cycle, including rules that establish the ex-dividend date for distributions by Nasdaq-listed companies.

In order to implement a T+2 settlement cycle, Nasdaq would modifyRule 11140(b)(1) to provide that the “ex-dividend date” will generally be the first business day before the record date. The ex-dividend date is the date on which a security is traded without the right to receive a dividend or distribution that has been declared by a listed issuer.

The following Nasdaq rules would also be impacted by this amendment:

Rule 2830 (Investment Company Securities, incorporated by reference from NASD Rule 2830)
Rule 11150(a) (Transactions “ex-interest” in bonds which are dealt in “flat”)
Rules 11210(c) and (d) (Confirmations)
Rule 11320(b) and 11320(c) (Dates of delivery)
Rule 11620 (Computation of interest)

Nasdaq anticipates filing rule amendments to accommodate the new T+2 settlement cycle later in 2016, and fully implementing T+2 settlement in the third quarter of 2017. Interested parties can submit comments prior to September 30, 2016.

ARTICLE BY Peter Rivas of Jones Walker LLP

Exclusive Study Analyzes 2015 IPOs

Proskauer’s Global Capital Markets Group presents the third annual IPO Study, a comprehensive analysis of U.S.-listed initial public offerings in 2015 and identification of three-year comparisons and trends of U.S.-listed initial public offerings over the same period.

The study examines 90 U.S.-listed 2015 IPOs with a minimum initial deal size of $50 million, and includes industry analysis on health care; technology, media & telecommunications; energy & power; financial services; industrials and consumer/retail. The study also includes a focus on foreign private issuers. It also makes year-over-year comparisons of extensive data about deal structures and terms, SEC comments and timing, financial profiles, accounting disclosures, corporate governance and deal expenses.

Underlying the study is the global Capital Markets Group’s proprietary IPO database, which is a valuable resource for sponsors and companies considering an IPO as well as for IPO market participants and their advisors.

Download Proskauer’s 2016 IPO Study

Article By Frank Lopez of Proskauer Rose LLP

SEC Releases Crowdfunding Rules for Securities Offerings

Investors will be able to purchase securities through Internet crowdfunding platforms under new final rules released by the Securities and Exchange Commission (SEC) in October. The final rules, known as “Regulation Crowdfunding,” originated in Title III of the Jumpstart Our Business Startups Act of 2012 (JOBS Act). The rules will take effect in May 2016.

Alongside Regulation Crowdfunding, the SEC also proposed amendments to Rules 147 and 504 under the Securities Act of 1933 (the Proposed Amendments). A brief review of Regulation Crowdfunding and the Proposed Amendments is provided below for companies or investors eager to discover new capital raising or investment opportunities and for broker-dealers interested in expanding into the crowdfund arena.

Key Points: What to Know About Regulation Crowdfunding

The Regulation Crowdfunding rules are extensive, but they can be more readily understood and categorized as: 1) operative provisions; 2) disclosure mandates; and 3) crowdfunding platforms.

Operative Provisions

Regulation Crowdfunding will: i) enable companies to raise up to $1 million, in the aggregate, over a 12-month period; ii) for individual investors whose annual income or net worth is less than $100,000, enable such investors to spend the greater of $2,000 or five percent of the lesser of their annual income or net worth on crowdfunding investments over a 12-month period; iii) for individual investors whose annual income or net worth equals or exceeds $100,000, enable such investors to spend ten percent of the lesser of their income or net worth on crowdfunding investments over a 12-month period. The goal is to allow more people to dabble in investments, and to level the playing field for investments by ensuring that even the wealthiest of individual investors cannot spend more than ten percent of their income or net worth on crowdfunding offerings in a given 12-month period. Also crucial to note are the following points:

Securities purchased in a crowdfunding transaction will be considered restricted securities and will be subject to resale restrictions for one year in most circumstances;
All of the new crowdfunding offerings will need to be completed with the assistance of a registered broker-dealer or done through a registered “funding portal,” to be discussed in greater depth below; and
Some companies are unable to use the exemption, including foreign companies, publicly-traded companies, and companies that are subject to disqualification under Regulation Crowdfunding.

Disclosure Mandates

Companies seeking to raise money through crowdfunding will have to meet specific disclosure requirements under Regulation Crowdfunding including:

The price of the securities to be offered;
How the price was determined;
The target offering amount;
The deadline to reach the target offering amount;
The funding deadline;
Whether the company intends to accept investments that will cause the target offering amount to be exceeded;
A discussion of the company’s financial health;
A discussion of the business and how proceeds from the offering will be used;
Information about directors, officers, and owners of 20 percent or more of the companies;
Certain related-party transactions; and
Financial statements of the company that may or may not need to be audited, depending on a fairly complex set of circumstances.

Crowdfunding Platforms

Regulation Crowdfunding contemplates the creation of crowdfunding portals to facilitate Internet-based transactions that, in theory, reduce costs and boost efficiency. The “funding portals” will need to be registered with the SEC via a new form – Form Funding Portal – and such portals will need to be registered as members of a national securities association (i.e., FINRA). In short, the funding portals will be the intermediary platforms through which all crowdfunding will be conducted, and these portals will need to comply with the following requirements:

Provide investors with informative materials explaining how to use the platform, what is being offered, and all relevant disclosures about the company, resale restrictions, investment limitations, and the like;
Take measures to reduce fraud risks, including by verifying with the companies offering securities that such companies are in compliance with Regulation Crowdfunding and that the companies are maintaining up-to-date records of their security holders;
Post and maintain mandatory disclosures for 21 days before any offerings are live (i.e., a waiting period of 3 weeks) and throughout the actual offering period;
Make available forums or other communication venues for investors to discuss offerings on the platform;
Explain how the intermediary is being compensated for hosting the transactions;
Require investors to set up accounts officially before being allowed to buy securities;
Have a reasonable basis to believe that investors are in compliance with the investment limitations (i.e., they will need to ensure investors are not exceeding their spending limits in a given 12-month period);
Provide adequate notices and confirmations at each step of the investment process;
Comply with maintenance and transmission of funds requirements; and
Comply with any requirements dealing with completion, cancellation, and re-confirmation of offerings requirements.

Crowdfunding intermediaries will be prohibited from providing access to companies they believe pose fraud or other problems that could negatively impact investor protections; holding financial interests in companies offering securities on their platforms, unless such financial interests are being used as consideration to pay the intermediaries for their services (subject to certain conditions); and paying third parties to provide information that will personally identify any investors or potential investors who may be using or planning to use the platform. Specific to funding portals as intermediaries, Regulation Crowdfunding also prohibits such portals from: offering investment advice or making purchase recommendations; soliciting purchases, sales, or offers; soliciting purchases, sales, or offers via promoters or other persons for pay; and holding or handling investors’ funds or securities. Despite the numerous prohibitions, Regulation Crowdfunding is intended to make transactions smoother and provide a safe harbor (i.e., set of guidelines) for funding portals, such that, if the portals follow the guidelines precisely, they can be assured that they are in compliance with Regulation Crowdfunding.

Key Points: What to Know About the Proposed Amendments

In an effort to balance the need to help smaller companies raise capital with the need to protect investors from fraudulent and misleading securities sales, the SEC has proposed amending Rules 147 and 504 as follows:

Rule 147 – This rule currently allows a safe harbor for exemption from costly registration for offers and sales made entirely within one state. The amendments are intended to make it easier for companies to make intrastate offerings of their securities by: 1) eliminating restrictions on offers (i.e., general solicitation and advertising will be allowed), though sales would still need to be made only to residents of the issuer’s state or territory; and 2) expanding the meaning of “intrastate offering” and the issuer eligibility requirements. The amended Rule 147 would apply to offerings registered in-state or conducted under an exemption from state law registration that caps the amount of securities allowed to be sold by an issuer at $5 million over a given 12-month period, along with spending limits for investors.
Rule 504 – This rule currently provides a safe harbor exemption from registration for certain small offerings. The amendments would boost capital-raising by increasing the aggregate amount of securities allowed to be offered and sold under Rule 504 from $1 million to $5 million, during any 12-month period. The amendments would boost protection for investors by prohibiting a set of defined “bad actors” from participating in such offerings.

Conclusion: Timelines for Regulation Crowdfunding and the Proposed Amendments

The new Regulation Crowdfunding rules and forms will be effective 180 days after they get published in the Federal Register (i.e., in May 2016). The forms that will enable funding portals to get registered with the SEC will become effective on January 29, 2016, thereby allowing the funding portals to be active or ready for transactions months before any transactions under the new rules are allowed by law.

Regarding the Proposed Amendments to Rules 147 and 504, the SEC is welcoming public comments, and will continue to do so for a 60-day period, which will end approximately by the end of the year. Crowdfunding has been the subject of much discussion and debate as evidenced by the nearly three years it took the SEC to promulgate Regulation Crowdfunding. It is still too early to predict whether crowdfunding will emerge in 2016 as a successful alternate path for capital-raising for small companies. Indeed, only time will tell whether the SEC will manage to balance its primary goal of investor protection with the ambitious aim of offering a more grassroots-level option of raising money.

To review the text of Regulation Crowdfunding and the Proposed Amendments, see the following links from the SEC: http://www.sec.gov/rules/final/2015/33-9974.pdf and http://www.sec.gov/rules/proposed/2015/33-9973.pdf.

Article By Corporate Services at Dickinson Wright of Dickinson Wright PLLC

Failure to Investigate Could Mean “Game-Set-and-Match” for EB-5 Investors: SEC Case against Brother-in-Law of Tennis Star Andre Aggasi Shows Risk for Would-be Immigrant Investors

On August 25, 2015, the U.S. Securities and Exchange Commission (SEC) filed a civil fraud suit against Lobsang Dargey, a Bellevue, Washington-based real estate developer and alleged fraudster, who also happens to be a brother-in-law of tennis star Andre Agassi. Dargey had ventured into the EB-5 Program as a developer and regional center owner, securing designation by United States Citizenship and Immigration Services (USCIS) for two regional centers, Path America SnoCo and Path America KingCo. The complaint is relevant to both investors and regional centers in the EB-5 industry, as well as to lawyers advising issuers in EB-5 offerings.

Dargey has now landed in hot water for engaging in fraud and deceit in the EB-5 offering process, as well as for using related Path America companies to siphon investor funds into his own pockets. The SEC has charged him for making false and misleading statements in EB-5 offering documents, alleging that since 2012 Dargey has exploited the EB-5 Program to defraud investors seeking investment returns and a lawful path to U.S. permanent residency. Among the allegations is misappropriation of $17.6 million in investor funds.

Summary of the SEC’s Complaint

The SEC alleges that Dargey, through his solely owned and controlled entity Path America, LLC, had diverted to himself and for his own personal benefit millions of dollars he had raised from Chinese nationals for EB-5 projects sponsored by Path America-owned regional centers. Path America had raised money for projects including the proposed Potala Farmers Market (a hotel, apartment and retail project in Everett, Washington), as well as the Potala Tower (a proposed 440 foot, 40-story hotel-and-apartment tower) in Seattle. Path America serves as the managing member of both USCIS designated regional centers and had unfettered control over the entire EB-5 investment process for the offerings.

In bringing the suit, the SEC also obtained a temporary asset freeze against Dargey and numerous related corporate defendants to prevent Dargey from pursuing his recently-announced plans to raise an additional $95 million from investors. According to the SEC, Dargey spent some of the siphoned funds on a $2.5 million home in Bellevue as well as at various gambling casinos. He also diverted EB-5 funds to projects that were unrelated to those disclosed in his offering documents to investors, meaning that the green card petitions pursued by EB-5 investors would be infirm.

A Path to America Fraught with Securities Fraud

The Path America case raises questions about investments buttressed by stories that seem to-good-to-be-true: Dargey left his Tibetan homeland and goat-herding profession in 1997 to pursue opportunities in the United States, as a house painter though he didn’t speak a word of English, and later rose to become a successful real estate developer. Dargey’s personal biography was almost certainly a lure to investors, and he conditioned the EB-5 market with his life story. In the media, Dargey touted his personal journey from Buddhism to capitalism, creating a background narrative for his real estate ventures and perceived success. Dargey’s story should caution investors to thoroughly examine the organizations backing the EB-5 projects in which they invest despite any personal affinity or connectivity with the background of a project promoter. Although the SEC has not directly asserted that this case involved affinity fraud, it is clear that Dargey targeted Chinese investors who may have felt an affinity with him. This is a common tactic employed by a schemer in affinity fraud.

If true, the allegations levied by the SEC make a strong case against Dargey for securities fraud, which is at the heart of the complaint. An element of any claim of securities fraud is the defendant’s state of mind, specifically, whether the defendant acted with “scienter” or “fraudulent intent.” Frequently, aggrieved investors in actions to recover their investment losses have tried to establish scienter by pointing to a defendant’s “motive and opportunity” to commit fraud. The Dargey case illustrates how control of numerous related entities involved in this EB-5 financing program may give a defendant ample “opportunity” to siphon off investor funds and commit fraud, while keeping investors in the dark about material changes to how he used investor funds. Nine different corporate entities were named as defendants in this case, and, according to the SEC’s Complaint, Dargey maintained control over all of them to such a degree that he was able to repeatedly transfer funds between the entities and into accounts that he controlled, eventually withdrawing large sums of cash which he used to gamble and purchase real estate. A quick records search on the State of Washington’s Secretary of State’s corporate records database reveals that Dargey (or a member of his executive team listed on his company website) is in fact the registered agent for each of these companies.

The Dargey case serves as a reminder to investors in EB-5 regional center projects (or any other investment vehicle) to be thorough and circumspect in evaluating the organizational structure of any enterprises set up to achieve the advertised goals, particularly where numerous inter-related projects are involved and particularly where the entire enterprise appears to be under the control of just one individual. Unlike Mr. Dargey’s rags-to-riches success story, some opportunities are just too good to be true.

Related Party Transactions Can Be Traps for Unwary EB-5 Regional Centers and Issuers

Regional centers and issuers of EB-5 investments should also consider carefully the lessons in Dargey’s case about potential SEC scrutiny of related party transactions.

USCIS designated regional centers that handle investor funds and that facilitate offerings also need to be cautious, even when they think they are doing everything properly. The SEC is showing an increased interest in the EB-5 Program, and this interest appears to be here to stay.

One hot topic is related party transactions that, when improperly concealed, keep investors in the dark about the economic relationships among multiple related entities in a deal. Disclosures about related party transactions should not be buried in a Private Placement Memo (PPM), but should be identifiable and written in clear language. If a regional center, developer and general partner are essentially one and the same party in your deal, your offering could be subject to a higher level of scrutiny later particularly with respect to whether all material disclosures were properly presented in offering documents. Related party transactions require careful and robust disclosures so that investors can evaluate the substance of potential conflicts. Such disclosures belong to the total mix of information that a reasonable investor would need to know in order to make an investment decision. The omission of such disclosures can lead to litigation later with the SEC and investors.

While transparency to investors is paramount, so too is fairness. If you are conducting an offering with related party transactions, ensure that you have a commercially reasonable basis for the economics of your deal. Also have objective controls on how investor funds are managed and spent. One practice tip is to engage an auditor that provides annual or even semi-annual or quarterly reports to investors. Even regional center owners or managers who don’t engage in criminal or egregious conduct can find the SEC knocking at the door and alleging fraud when material facts in a deal are not disclosed to investors, or when there are questions about how investor funds were handled.

Another strategic tip: hire qualified securities counsel to understand what you need to disclose in your offering documents when you have a related party transaction. What constitutes a material disclosure is complex. Suffice it to say that counsel needs to be engaged in all aspects of an offering’s preparation to guide an issuer on whether disclosures are sufficient when a deal goes to market. An omission could result in allegations or findings later that offering documents contained false or misleading statements. An omission of a material fact about related party transactions can have dire consequences including rescission in favor of investors, an SEC finding of securities fraud under Section 10(b) of the 1933 Securities Act and exposure under Rule 10b-5, one of the most important rules promulgated by the SEC with respect to securities fraud. Allegations by the SEC that an issuer or regional center has made false and misleading statements in an offering process can lead to assets being frozen and costly civil fraud litigation, particularly where the SEC can show opportunity to commit fraud through related party dealings.

How Can Regional Centers and Issuers of EB-5 Securities Mitigate Litigation Risks?

Every EB-5 regional center or issuer should consider adding a securities litigator to the offering team before introducing a deal into the marketplace. In the current climate, guidance on risk mitigation in an offering is critical. Having counsel involved early on during drafting sessions of an offering is an effective way to understand your disclosure obligations as you prepare a PPM. A securities litigator following the lifecycle of your offering – from inception of a business plan to closing of a deal – can serve as an excellent advisor to issuers in preventing problems and miscommunications with investors and government agencies. In the current climate, risk mitigation is an important component of EB-5 regional center business planning and operations.

Conclusion

The SEC is the ultimate referee in an EB-5 deal. Playing ball by the rules matters, especially when it comes to ensuring that material facts are disclosed to investors. Disclosures are the “sweetspot” of a PPM. A PPM without the right disclosures is about as effective as tennis racquet with no sweetspot. You’ve lost the match before the first serve.

If SEC litigation increases in the EB-5 realm, then we expect that otherwise lawabiding and compliant regional centers could be inadvertently swept up into costly litigation. This will be true even with regional centers who make a good faith effort to comply with the law. An SEC complaint against your regional center could seriously impede your ability to do business, even if you have the law and facts in your court. Therefore, now’s the time to add securities litigation counsel to your EB-5 team, if you haven’t done so already. Securities litigation counsel experienced in the purchase and sale of securities, the Foreign Corrupt Practices Act (FCPA), disputes with the SEC over what constitutes materiality in an offering, and other relevant areas can help you mitigate risk, protect investors and raise funds as you intended.

Article By Adam L. Sisitsky & Douglas Hauer of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

Sunlight is the best disinfectant: SEC charges oil company for fraud on EB-5 investors

In a recent action, SEC v. Luca International Group, LLC et al. (“SEC v. Luca“), the Securities and Exchange Commission (SEC) has charged a California-based oil and gas company and its CEO with violations of securities laws in connection with a $68 million Ponzi scheme and affinity fraud. The target of the fraud was the Chinese American community. Additionally, a portion of the funds raised by the defendants came from EB-5 investors seeking green cards through the EB-5 Program. The SEC issued both a press release and cease and desist order this week in connection with this most recent action. We think that this case highlights two important and relevant points for our readership, and that the SEC exposing the defendant schemers/fraudsters in SEC v. Luca is good for the EB-5 industry and integrity of the EB-5 program.

Prosecution efforts are going global– government agencies in Hong Kong and China assisted the SEC’s efforts

Now more than ever before, the SEC is on the path to closing down actors in the EB-5 context that engage in deception and fraud. We are in a new era of enforcement, with the SEC becoming more familiar with the EB-5 Program. We think that this enforcement trend will move at an even faster clip as the SEC and United States Citizenship and Immigration Services (USCIS) become more agile in cooperating and responding to credible allegations of fraud.

EB-5 regional centers and issuers need to put into place sound and workable policies to ensure that marketing practices are in line with securities laws. Note that in SEC v. Luca, there was cooperation with the SEC and two foreign agencies, namely the Hong Kong Securities and Futures Commission and the China Securities and Regulatory Commission. Enforcement and prosecution efforts in this context are going global. Regional centers and issuers should ensure that any offshore sales efforts are in compliance with the laws of the countries in which sales activities are performed.

Overlooked federal and state investment adviser registration requirements

SEC v. Luca is a reminder that investment adviser requirements may apply broadly in EB-5 transactions and require federal or state registration by regional centers, issuers and/or EB-5 deal facilitators. In SEC v. Luca, the SEC asserted that the defendants acted as “investment advisers” within the meaning of Section 202(a)(11) of the U.S. Investment Advisers Act of 1940 (“Advisors Act”) [15 U.S.C. Section 80(b)-2(a)(11), but had no registrations with the Commission. Confusion over investment adviser registration requirements is a commonplace problem in the EB-5 space. In SEC v. Luca, the defendants were in the business of providing investment advice concerning securities for compensation. According to the SEC, these key facts triggered registration requirements under the Advisers Act.

We will soon be providing an extensive alert with regulatory advice to EB-5 regional centers and issuers on the applicability of both federal and state investment adviser registration requirements. The applicability of such requirements should be made on a case-by-case with qualified securities counsel. There is no “one size fits all” advice. States have their own considerations in interpreting investment adviser registration requirements. And the SEC has its own interpretive guidance on the parameters of the registration requirements of the Advisers Act apply.

Conclusion

The egregious pattern of unlawful behavior by the defendants in SEC v. Luca included deceit in the marketing process, fraud in offering materials, comingling and misappropriation of funds, and violation of registration requirements. These are issues not just in the EB-5 context, but with private placements generally. Affinity fraud is also common in private placements.

EB-5 stakeholders should be aware that we are seeing a visible uptick in securities related prosecutions. No issuer, regional center or deal facilitator is immune from scrutiny. The SEC and USCIS are also working together more nimbly with foreign securities agencies. Sound policies, securities compliance and meaningful due diligence by experts are important in EB-5 offerings.

Sunlight is the best disinfectant. This adage is true for the EB-5 program. Stakeholders who promote a transparent and strong EB-5 program should applaud the SEC’s efforts.

ARTICLE BY Douglas Hauer of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

Senator Elizabeth Warren Criticizes SEC Chair Mary Jo White for “Extremely Disappointing” Leadership

In a letter dated June 2, 2015, Senator Elizabeth Warren described several “promises” that Mary Jo White, chair of the Securities and Exchange Commission, had allegedly broken. Senator Warren focused on (1) the SEC’s failure to finalize Dodd-Frank rules requiring disclosure of the ratio of CEO pay to that of the median worker; (2) settlement of enforcement actions without requiring admissions of wrongdoing; (3) grants of waivers to well-known seasoned issuers (WKSIs) found to have violated securities laws; (4) Chair White’s recusals due to her prior employment and her husband’s continuing employment at Wall Street defense firms; (5) the lack of proposed rulemaking to address disclosure of corporate campaign spending; (6) the “watered down” Rule ABII governing disclosures for asset-backed securities; and (7) new rules for small business capital formation that preempt state consumer protection laws. In particular, Senator Warren highlighted statements that Chair White made in various personal meetings about the timeline to finalize CEO pay disclosure rules, and cited several statistics concerning admissions of wrongdoing, waivers to WKSIs, and recusals. For example, in 520 settlements, the SEC required admissions of guilt in only 19 cases, and 11 of those involved only factual admissions. Under Chair White, the SEC granted 20 of 38 waiver requests. Chair White reportedly has recused herself from nearly 50 investigations due to her prior employment and has recused herself from approximately 10 investigations due to her husband’s current employment. Senator Warren closed the letter with demands for detailed information concerning the CEO pay rule, settlements and admissions of guilt, waivers, recusals, and campaign finance disclosures.

A copy of the letter is available here.

ARTICLE BY Michael S. Gordon & Tenley Mochizuki of Katten Muchin Rosenman LLP

Second Circuit Dismisses Suit Over FBI’s Wiretapping of Marital Conversations in Securities Fraud Investigation

Federal Bureau of Investigation (FBI) wiretapping played an important role in the wide-ranging insider trading investigation and subsequent trials of Galleon Group LLC principals and traders. During his criminal prosecution, former Galleon trader, Craig Drimal, unsuccessfully moved to suppress evidence obtained via an authorized wiretap of his cell phone because of a failure to minimize interception of calls with his wife. His wife, Arlene Villamia Drimal, is now pursuing civil claims against FBI agents for wiretapping her personal telephone conversations with her husband, but her claims have thus far been unsuccessful. On May, 15, the US Court of Appeals for the Second Circuit dismissed Ms. Drimal’s complaint without prejudice to repleading, finding that her conclusory pleading failed to state a claim under Title III of the Omnibus Crime Control and Safe Streets Act of 1968, which requires the government to “minimize the interception of communications not otherwise subject to interception.” The Second Circuit also found fault with the lower court’s assessment of the agents’ qualified immunity defense.

In connection with a federal criminal investigation, the US District Court for the Southern District of New York authorized a wiretap of Mr. Drimal’s cell phone, but stressed that monitoring must “immediately terminate when it is determined that the conversation is unrelated [to criminal matters].” FBI agents also were instructed to “discontinue monitoring if you discover that you are intercepting a personal communication solely between husband and wife.” Despite these instructions, agents allegedly monitored approximately 180 private marital calls between the Drimals that were unrelated to the investigation. Although the district court denied Mr. Drimal’s suppression motion in his criminal matter, it identified 18 calls that were “potentially violative” and observed that the agents’ failure to minimize monitoring of private calls was “inexcusable and disturbing.” Ms. Drimal brought her separate civil lawsuit following the conclusion of her husband’s criminal case with his entry of a guilty plea and subsequent sentencing.

At the district court level, the FBI agents unsuccessfully moved to dismiss Ms. Drimal’s complaint for failure to state a claim and on qualified immunity grounds. The Second Circuit reversed that decision, holding that Ms. Drimal’s complaint was insufficient because it merely stated, in a conclusory fashion, that the interception of marital calls violated Title III, without reference to a duty to minimize. The Second Circuit noted that Title III does not prohibit outright the monitoring of privileged calls. With respect to the agents’ qualified immunity defense, the court of appeals held that the district court should have evaluated each agent’s minimization efforts under an “objective reasonableness” standard based on the particular circumstances, rather than as a group. The Second Circuit vacated the lower court decision and directed dismissal of the complaint with leave to replead, stating that amending the complaint would not be futile.

Drimal v. Makol, Nos. 13-2963 and 13-2965 (2d Cir. 2015)

ARTICLE BY Emily Stern & Margaret J. McQuade of Katten Muchin Rosenman LLP

Category: Securities Law

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