Securities Mosaic® Blogwatch
June 22, 2018
Wachtell Lipton Discusses Shareholder Activism, Corporate Governance, and the Hunt for Long-Term Value
by Sabastian V. Niles

As the spotlight on boards, management teams, corporate performance and governance intensifies, as articles like the Bloomberg and Fortune profiles of Elliott Management (“The World’s Most Feared Investor—Why the World’s CEOs Fear Paul Singer” and “Whatever It Takes to Win—How Paul Singer’s Hedge Fund Always Wins”) and other activist investors become required reading in every boardroom and C-suite, and as activist campaigns against successful companies of all sizes increase worldwide, below are fifteen themes expected to impact boardroom, CEO and investor behavior and decision-making in the coming years.

1. The CEO, the Board and the Strategy

  • The relationship of the CEO with fellow directors will remain the most important, overriding corporate relationship a CEO has.
  • Strengthening that relationship, addressing disconnects openly and directly, and ensuring internal clarity and alignment between the board and management should be prioritized before an activist, takeover threat or crisis emerges.
  • Boards of directors will become more actively involved with management in developing, adjusting and communicating the company’s long-term strategy and operational objectives and anticipating threats to progress.

2. Activism Preparedness Grows Up.

  • Instead of a check-the-box housekeeping exercise, companies will pursue real readiness for activist attacks.
  • Activism preparedness will be integrated into crisis preparedness, strategic planning and board governance.
  • This will include periodic updates for the board by expert advisors working with management; non-generic break glass plans; a philosophy of continuous improvement and rejecting complacency; training, simulations and education informed by live activism experiences; expert review of bylaws and governance guidelines; and cultivating third-party advocates early.
  • Most importantly, deep self-reflection and self-help will identify opportunities for strengthening the company and increasing sustainable value for all stakeholders, mitigating potential vulnerabilities, getting ahead of investor concerns and ensuring that the company’s strategy and governance is well-articulated, updated and understood.
  • The CEO and other directors will be prepared to deal with direct takeover and activist approaches and handle requests by institutional investors and activists to meet directly with management and independent directors.

3. Companies Standing Up, Playing Offense and Showing Conviction without Capitulation.

  • Well-advised companies will take a less reactive posture to activist attacks, find opportunities to control the narrative, strengthen their positioning and leverage with key investors and stakeholders and understand investor views beyond the activist.
  • Directors and management will maintain their composure and credibility in the face of an activist assault and not get distracted or demoralized.
  • Companies will proactively take action and accelerate previously planned initiatives with wide support to demonstrate responsiveness to investor concerns without acceding to an activists’ more destructive or short-sighted demands.
  • If a legitimate problem is identified, consider whether the company has a different (better) approach than the one proposed by the activist, and if the activist’s idea is a good one, co-opt it.
  • Companies with iconic brands and a track record of established trust will protect – and appropriately leverage – their brands in an activist situation.
  • Negotiating and engaging with an activist from a position of strength rather than fear or weakness will become more common.

4. Activists Standing Down.

  • Through deft handling and prudent advice, more activist situations will be defused and never become public battles, including where the activist concludes they would be better served by moving on to another target.
  • Companies who move quickly to pursue the right initiatives, maintain alignment within the boardroom and engage in the right way with key shareholders and constituencies will achieve beneficial outcomes, gain the confidence of investors beyond the activist and, where dealmaking with an activist is needed, find common ground or obtain favorable settlement terms.

5. “Shock, Awe & Ambush” Meets the Power of Behind the Scenes Persuasion.

  • Until activism evolves, boards and management teams will continue to grapple with activists who mislead, grandstand, goad, work the media, threaten and bully to get their way.
  • But major investors will increasingly reject such irresponsible engagement and more interesting flavors of activism will emerge, led by self-confident and secure funds who value thoughtful, private discussions as to how best to create medium-to-long- term value, respect that boards and management teams may have superior information and expertise and valid reasons for disagreeing with an activist’s solutions, and pursue collaborative, merchant banking approaches intended to assist a company in improving operations and strategies for long-term success without worrying about who gets the credit.
  • In some situations, working with the right kind of activist and showing backbone against misaligned activist funds and investors will deliver superior results.

6. Better Index IR and Not Taking the Passives (or Other Investors) for Granted.

  • BlackRock, State Street and Vanguard will continue to bring their own distinctive brands of stewardship, engagement and patient pressure to bear in the capital markets and at their portfolio companies.
  • Companies will increasingly recognize that a classical “governance roadshow” promoting a check-the-box approach to governance without a two-way dialogue is a missed opportunity to demonstrate to these funds that the company’s strategic choices, board and management priorities and substantive approach to governance deserve support from these investors.
  • More sophisticated and nuanced approaches for gaining and maintaining the confidence of all investors will emerge.
  • Engagement for engagement’s sake will fall out of favor, and targeted, thoughtful and creative approaches will carry the day.

7. Quarterly Earnings Rituals.

  • While quarterly earnings rituals will remain, for now, a fact of life in the U.S., companies and investors will explore alternatives for replacing quarterly rhythms with broader, multi-year frameworks for value creation and publishing new metrics over timeframes that align with business, end market and operational realities. Giving quarterly guidance will fall out of favor and be increasingly criticized.
  • In the U.K. and other jurisdictions that permit flexibility, more companies will move towards non-quarterly cadences for reporting and issuing guidance and seek to attract more long-term oriented investor bases by publishing long-term metrics.
  • In all markets, companies will increasingly discuss near-term results in the context of long-term strategy and objectives, more management time will be spent discussing progress towards important operational and financial goals that will take time to achieve and sell-side analysts will have to adapt to a more long-term oriented landscape or find their services to be in less demand.

8. Embracing the New Paradigm and Long-Termism.

  • The value chain for alignment towards the long-term across public companies, asset managers, asset owners and ultimate beneficiaries (long-term savers and retirees) – each with their own time horizons, goals and incentives – is now recognized as broken.
  • Organizations and initiatives like Focusing Capital on the Long Term, the Coalition for Inclusive Capitalism, the World Economic Forum’s New Paradigm and Roadmap for an Implicit Corporate Governance Partnership to Achieve Sustainable Long-Term Investment and Growth, the Conference Board, the Strategic Investor Initiative, the Aspen Institute’s Business & Society Program and Long-Term Strategy Group and others will increasingly collaborate and perhaps consolidate their efforts to ensure lasting change in the market ecosystem occurs.
  • Additional academic and empirical evidence will be published showing the harms to GDP, national productivity and competitiveness, innovation, investor returns, wages and employment from the short-termism in our public markets.
  • Absent evidence that private sector solutions are gaining traction, legislation to promote long-term investment and regulation to mandate long-term oriented stewardship will be pursued worldwide.

9. Convergence on ESG and Sustainability.

  • Companies will increasingly own business-relevant sustainability concerns, integrate relevant corporate social responsibility issues into decision-making and enhance disclosures in appropriate ways, while resisting one-size-fits-all approaches delinked from long-term business imperatives.
  • ESG-ratings services will come under heightened pressure to improve their quality, achieve consistency with peer services, eliminate errors and proactively make corrections or retract reports and ratings.
  • Activist hedge funds will continue to experiment with ESG-themed or socially responsible flavored campaigns to attract additional assets under management, drive a wedge between companies and certain classes of ESG-aligned investors and try to counter their “bad rap” as short-term financial activists who privilege financial engineering and worship the immediate stock price.
  • Mainstream investors will increasingly try to apply and integrate ESG-focused screens and processes into investment models.

10. Dealing with the Proxy Advisory Firms.

  • While proxy advisory firms will increasingly become disintermediated, including through efforts like the U.S. Investor Stewardship Group (ISG) and increased investments by active managers and passive investors in their own governance teams and policies, proxy advisors will retain the power to hijack engagement agendas and drive media narratives.
  • More scrutiny will be brought to bear when advisory firms overreach, where special interests drive a new proxy advisory firm policy and if investors reflexively follow their recommendations.
  • Especially in contested situations, winning the support of the major proxy advisory firms is valuable, but well-advised companies will succeed in convincing investors to deviate from negative recommendations and in special cases persuading advisory firms to reverse recommendations.
  • Negative recommendations will be managed effectively without letting the proxy firm dictate what makes sense for the company.

11. Board Culture, Corporate Culture and Board Quality.

  • Leaders who promote a board culture of constructive support and engaged challenge and who foster a healthy and inclusive corporate culture will outperform.
  • Vibrant board and corporate cultures are valuable assets, sources of competitive advantage and vital to the creation and protection of long-term value.
  • Board strength, composition and practices will be heavily scrutinized, including as to director expertise, average tenure, diversity, independence, character, and integrity.
  • Nuanced evaluations of the ongoing needs of the company, the expertise, experience and contributions of existing directors, and opportunities to strengthen the current composition will be integrated into proactive board development plans designed to enable the board’s composition and practices to evolve over time.
  • Failure to evolve the board and its practices in a measured way will expose companies to opportunistic activism and takeover bids.
  • Boards and management teams who know how to navigate stress, pressure, transition and crisis will thrive.

12. Capital Allocation.

  • Investors will have more heated debates among themselves and with companies about preferred capital allocation priorities, both at individual portfolio companies and at an industry level.
  • Companies will be more willing to reinvest in the business for growth, pursue smart and transformative M&A that fits within a longer-term plan to create value and make the case for investments that will take time to bear fruit by explaining their importance, timing and progress.
  • Prudently returning capital will remain a pillar of many value creation strategies but in a more balanced way and with more public discussion of tradeoffs between dividends versus share repurchases and alternative uses.
  • Investors may not agree with choices made by companies and will disagree with each other.

13. Directors as Investor Relation Officers.

  • While management will remain the primary spokesperson for the company, companies will better prepare for director-level interactions with major shareholders and become more sophisticated in knowing when and how to involve directors – proactively or upon appropriate request – without encroaching upon management effectiveness.
  • Directors will be deployed carefully but more frequently to help foster long-term relationships with key shareholders.
  • However, directors will need to be vigilant to ensure the company speaks with one voice and guard against attempts by investors to pursue inappropriate one-off engagements and foster mixed messages.

14. The General Counsel as Investor Relations Officer.

  • The general counsel (or its designee, such as the corporate secretary or other members of the legal staff) will play an increasingly central role in investor relations functions involving directors, senior management and the governance and proxy voting teams at actively managed and passive funds alike.
  • Board and management teams will look to the general counsel to advise on shareholder requests for meetings to discuss governance, the business portfolio, capital allocation and operating strategy, and the board’s practices and priorities and to evaluate whether given demands of corporate governance activists will improve governance or be counterproductive.

15. The Nature of Corporate Governance.

  • Questions about the basic purpose of corporations, how to define and measure corporate success, the weight given to stock prices as reflecting intrinsic value, and how to balance a wider range of stakeholder interests (including employees, customers, communities, and the economy and society as a whole) beyond the investor will become less esoteric and instead become central issues for concern and focus within corporate boardrooms and among policymakers and investors.
  • Measuring corporate governance by how many rights are afforded to a single class of stakeholder – the institutional investor – will be seen as misguided.
  • Corporate governance will increasingly be viewed as a framework for aligning boards, management teams, investors and stakeholders towards long-term value creation in ways that are more nuanced and less amenable to benchmarking and quantification.

This post comes to us from Wachtell, Lipton, Rosen & Katz. It is based on the firm’s memorandum, “Board Ready: Shareholder Activism, Corporate Governance and the Hunt for Long-Term Value,” dated June 11, 2018, and available here.

June 22, 2018
A Public Option for Bank Accounts (or Central Banking for All)
by John Crawford, Lev Menand, Morgan Ricks

Among the perks of being a bank is the privilege of holding an account with the central bank. Unavailable to individuals and nonbank businesses, central bank accounts pay higher interest than ordinary bank accounts. Payments between these accounts clear instantly; banks needn’t wait days or even minutes for incoming payments to post. On top of that, central bank accounts consist of base money, meaning they are fully sovereign and nondefaultable no matter how large the balance. By contrast, federal deposit insurance for ordinary bank accounts maxes out at $250,000—a big problem for institutions with large balances.

Our paper recently posted on SSRN, A Public Option for Bank Accounts (or Central Banking for All), argues that restricting central bank accounts to an exclusive clientele (banks) is no longer justifiable on policy grounds if indeed it ever was. We propose giving the general public—individuals, businesses, and institutions—the option to hold accounts at the central bank, which we call FedAccounts. FedAccounts would offer all the functionality of ordinary bank accounts with the exception of overdraft coverage. They would also have all the special features that banks currently enjoy on their central bank accounts, as well as some additional, complementary features. Government-issued physical currency is already an open-access resource, available to all; the FedAccount program would merely do the same for nonphysical or “account” money.


The FedAccount program would bring genuinely transformational change to the monetary-financial system, in ways both obvious and unexpected. Perhaps most obviously, it would foster financial inclusion. Millions of “unbanked” and “underbanked” households are currently ill-served by the mainstream U.S. payment system. FedAccounts, properly structured, would be a money-and-payments safety net for such households, lessening their reliance on expensive and subpar alternatives.

But FedAccounts would hold appeal across the income and wealth spectrum. The interest rate paid on central bank accounts (known as the interest-on-reserves or IOR rate) would be very attractive to large businesses and other institutions. Equally appealing to large institutions would be the sovereign and nondefaultable status of these balances. FedAccounts would be pure base money, an asset not realistically available elsewhere in “account” form. Further, free instant payments among FedAccount holders would create network effects: the system’s value to existing users would rise as more users joined. For all these reasons, we expect that take-up would be robust.

If adopted on a large scale, FedAccounts would bring about less obvious, but no less profound, systemic changes. Financial stability would be dramatically enhanced: we expect that FedAccounts would crowd out unstable, privately issued deposit substitutes, which are central to financial instability. Monetary control and monetary policy transmission would improve: current problems with “pass through” of policy rates would diminish or disappear. Also, because the Federal Reserve would not charge interchange fees on debit card transactions, FedAccounts would eliminate an implicit tax on retailers and consumers. Moreover, the system could usher in desirable regulatory simplification. Far from being fiscally expensive, we expect FedAccounts to generate revenue for the federal government—possibly a lot of it—all while imposing minimal or potentially zero user fees.

In the paper, we consider how the FedAccount program would affect the central bank, the banking system, and financial “intermediation” more generally. We find these effects salutary. We also compare the FedAccount program to several loosely related reform proposals: full-reserve banking, postal banking, and central bank “digital” or “crypto” currencies. FedAccount compares favorably. Finally, we anticipate objections on various grounds, including institutional competence; law enforcement and counterterrorism; cybersecurity and fraud prevention; privacy and civil liberties; the availability of supposedly better alternatives, such as regulatory mandates or Fintech payment solutions not involving direct government provisioning; possible effects on lending, small banks, and financial innovation; the loss of purported synergies between deposits and lending; and possible political obstacles to adoption. We address these objections and find them wanting.

The full paper is available here. A shorter version, geared toward a policy audience, is available here.

June 22, 2018
Gender Quotas on California Boards
by Andrew Freedman, Ron Berenblat, Steve Wolosky, Olshan Frome Wolosky

California could become the first state in the nation to enact legislation promoting gender diversity in corporate boardrooms. On May 31, 2018, the State Senate of California passed a bill that would require public companies headquartered in California to comply with certain gender quota requirements with respect to board composition.

The bill, if enacted, would require any “publicly held” domestic and foreign corporation whose principal executive offices, according to the corporation’s Form 10-K, are located in California to have a minimum of one “female” on its board of directors no later than December 31, 2019. No later than December 31, 2021, the required minimum would increase to 2 female directors for corporations with 5 directors or to 3 female directors for corporations with 6 or more directors. The bill defines a “female” as “an individual who self-identifies her gender as a woman, without regard to the individual’s designated sex at birth.” A “publicly held” corporation is defined as a corporation with shares listed on “a major United States stock exchange.”


If the bill is enacted, the Secretary of State would publish on its website reports documenting compliance by affected corporations and fines would be imposed on those that fail to comply. For a first violation, the fine would be an amount equal to the average annual cash compensation for the directors of the corporation. For any subsequent violation, the fine would be an amount equal to three times the average annual cash compensation for directors of the corporation.

In the introduction of the bill, the Senate declared that:

More women directors serving on boards of directors of publicly held corporations will boost the California economy, improve opportunities for women in the workplace, and protect California taxpayers, shareholders, and retirees, including retired California state employees and teachers whose pensions are managed by CalPERS and CalSTRS. Yet studies predict that it will take 40 or 50 years to achieve gender parity, if something is not done proactively.

The California Senate must be commended for taking a leading role in addressing gender diversity. However, there is no certainty the bill will be enacted. It must pass the California State Assembly and then be approved by Governor Jerry Brown before taking effect. In addition, certain special interest groups and other critics are voicing constitutionality and technical concerns with the legislation and warning of unintended consequences such as the potential displacement of racially diverse board members and “overboarding” of the more experienced female directors.

Nevertheless, the volume of research showing a correlation between boards represented by women and improved performance can no longer be ignored, and we expect other states to advance similar legislation. In addition to California, five other states (MA, IL, PA, OH and CO) have already passed precatory resolutions encouraging corporations within their states to promote gender diversity in the boardroom. Major institutional investors are also prioritizing their efforts to foster greater gender diversity within the boards of their portfolio companies. In its latest proxy voting guidelines, BlackRock states that it “would normally expect to see at least two women directors on every board.” State Street will vote against the election of directors at portfolio companies that fail to take adequate measures to address the absence of female directors.

June 22, 2018
This Week In Securities Litigation (Week ending June 22, 2018)
by Tom Gorman

Decisions by the Supreme Court were key this week. The High Court concluded that SEC ALJs were appointed in violation of the Constitution. In reaching that conclusion the Court sidestepped a second constitutional question as well as the issue of whether the earlier efforts of the SEC to cure its incorrect appointment process were adequate, leaving the remedy issue open for all but the Petitioner in the case. The Court also agreed to hear a question regarding the Commission’s long standing efforts to blur the line between primary and secondary liability next term. That case has the potential to impact not just Commission actions but also securities class actions.

The DOJ brought criminal charges against the founder and COO of once high flying Theranos. Each executive was charged with conspiracy and multiple counts of wire fraud.

The Commission filed its second action in which admissions were required. The case centered on a years long deception by brokerage giant Merrill Lynch. The agency also brought an action based on an offering fraud executed by former market professionals and another case involving a a microcap market manipulation.


Testimony: Chairman Jay Clayton testified before the House Committee on Financial Services (June 21, 2018). His testimony detailed the work of the Commission and the various staff Divisions, beginning with the new draft Strategic Plan (below) and reviewed issues regarding improving disclosure and the capital raising process, cybersecurity, ICO’s, the consolidated audit trail and the remaining Dodd-Frank rules to be written (here).

Strategic Plan: The Commission issued a draft Strategic Plan for fiscal years 2018 – 2022, inviting comment (here). The draft discusses the Commission’s mission, vision, values and goals.

Remarks: Chairman Jay Clayton delivered remarks titled Observations on Culture at Financial Institutions and the SEC, New York, New York (June 18, 2018)(here). His remarks began by focusing on a paper from the U.K.’s Financial Conduct Authority regarding culture, noted the importance of culture in the context of compliance and concluded with a review of the obligations of professionals who work in the financial services industry.

Supreme Court

Lucia v. SEC, No. 17-130 (Decided June 21, 2018) resolved the question of whether SEC ALJs had to be appointed in accord with the dictates of the Constitution’s Appointments Clause – that is, are they Inferior Officers of the United States? The Court, in a 7-2 decision written by Justice Kagan, held that they are — the Clause applies and the ALJs should have been appointed in accord with its dictates rather than hired by the staff.

The Court’s decision is based largely on Freytag v. Commissioner, 501 U.S. 868 (1991) which “says everything necessary to decide this case,” according to the Court. There the Court concluded that certain tax court judges were Officers to which the Clause applied. SEC ALJs have similar duties and obligations to the judges at the tax court. Specifically, their positions have been established by law and they exercise significant discretion in creating the record for and presiding over administrative proceedings as in Freytag.

Since the ALJ who presided over Petitioner’s hearing was not appointed in accord with the Clause, a new proceeding must be brought and presided over by either the Commission or a different ALJ who has been appointed in accord with the dictates of the Clause. In reaching this conclusion the Court side-stepped the question of whether the Commission’s November 2017 order ratifying the appointment of its ALJs was adequate.

Justice Breyer dissented in part in an opinion joined by Justices Ginsburg and Sotomayor. In his opinion the Justice argued that a necessary predicate to the Appointments Clause question is one that the Solicitor General raised but the which the Court declined to consider. It centers on the application of the Administrative Procedure Act which provides for the retention of ALJs by the agency but not for the delegation of that authority to the staff. Consideration of this point could permit the Court to avoid the constitutional issue under the Appointments Clause. In addition, Free Enterprise Fund v. Public Company Accounting Oversight Bd., 561 U.S. 477 (2010) held that certain employment protections given to PCAOB board members violated the Constitution’s Vesting Clause. If that holding applied here to SEC ALJs — the Free Enterprise Court distinguished PCAOB Board members from ALJs – it would make the ALJ’s subject directly to the political processes by stripping them of their APA employment protections. This would threaten to “change the nature of our merit-based civil service as it has existed from the time of President Charles Alan Arthur,” the Justice cautioned in an argument that echoes his dissent in Free Enterprise Fund.

Lorenzo v. SEC, No. 17-1077 (certiorari granted June 18, 2018). The Supreme Court agreed to hear this case and determine a key question regarding the distinction between primary and secondary liability. Specifically, the question for resolution, according to petitioner, is as follows: “In Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011), this Court considered the elements of a fraudulent statement claim and held that only the ‘maker” of a fraudulent statement may be held liable for that misstatement under Section 10(b). . .The question presented is whether a misstatement claim that does not meet the elements set forth in Janus can be repackaged and pursued as a fraudulent scheme claim.” The resolution of this question has significant implications for SEC enforcement as well as private securities class actions.

SEC Enforcement – Filed and Settled Actions

Statistics: Last week the SEC filed 4 civil injunctive cases and 1 administrative proceeding, excluding 12j and tag-along proceedings.

Offering fraud: SEC v. Hocker, Civil Action No. 4:18-cv-01251 (M.D.Pa. Filed June 21, 2018) is an action which named as a defendant insurance agent James Hocker. Over a seven year period beginning in 2010 Mr. Hocker targeted his former insurance clients and inexperienced investors, inducing them to invest with him in ventures promised to pay returns ranging from 10% to 30%. About 25 investors entrusted Mr. Hocker with a total of $1.27 million. Rather than invest the funds, Mr. Hocker misappropriated them, according to the complaint. That complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 24173 (June 21, 2018).

Deception: In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Adm. Proc. File No. 3-18549 (June 19, 2018). Over a five year period which ended in 2013 Merrill Lynch engaged in a practice known internally at the firm as “masking.” The practice involved deceiving customers – primarily financial institutions such as asset managers, mutual fund investment advisers and pension funds – about the manner in which their trades were executed. Specifically, the brokerage firm often routed customer orders to other broker-dealers, proprietary traders and market makers for execution. The practice was called Electronic Liquidity Partners or ELP. Not only did Merrill Lynch fail to tell customers about the practice, the firm deceived the traders about the manner in which their transactions were executed to the point of altering customer documents. The practice was used even where the broker received express instructions not to execute the transactions using an ELP. Despite the fact that the information about the venue and execution was important to the traders, the firm deceived them. During the five year period of the scheme over 5.4 billion shares were traded in this manner with a notional value of $141 billion. Throughout the period Merrill Lynch knew internally where the transactions were executed. Those records were maintained internally and available for regulators. In 2013 the firm elected to halt the practice but did not inform its customers. The Order alleges violations of Securities Act Sections 17(a)(2) and (3). To resolve the proceeding Merrill Lynch admitted to the facts alleged in the Order and that its conduct violated the federal securities laws. The firm consented to the entry of a cease and desist order and a censure. It also agreed to pay a penalty of $42 million.

Investment fraud: SEC v. Santillo, Civil Action No. 18-cv-5491 (S.D.N.Y. Filed June 19, 2018) is an action which names as defendants five individuals who are or were members of FINRA, although two have been either suspended or barred from association: Perry Santillo; Christopher Parris; Paul Larocco; John Picarreto; and Thomas Brenner. Also named as defendants are three entities: First National Solution, LLC; Percipience Global Corporation; and United RL Capital Services. Defendants Santillo and Parris purchase books of business from investment professionals. Once the acquisition was completed the two men, with the assistance of the other defendants, induced the clients to withdraw from their existing investments and put their investment dollars into one of the entity defendants. Thus, for example, investors who were clients of an acquired business would be induced to invest in First Nationale, a firm that purports to conduct business in areas that include leveraged investments, the financial services industry and others. In other instances investors would be induced to withdraw from existing investments and place their money in Percipience, supposedly a firm that provides loans to buy and improve homes. In other instances investors would be solicited to invest in United RL, a firm supposedly in the business of financing physician-owned toxicology laboratories. In each instance investors were solicited using misrepresentations regarding the nature of the business, the use of their funds and other matters. Investors were furnished with false statements about their investments. Investors were not told that in fact the three firms had virtually no business, that large portions of the solicited funds were being recycled to pay other investors and that the individual defendants were misappropriating large portions of the money. Of the $102 million raised by defendants at least $38.5 million was paid out to earlier investors and $20 million was transferred to personal bank accounts of individual defendants. A large portion of the remaining funds were transferred elsewhere in transactions that are not recorded on the books. The complaint alleges violations of Securities Act section 17(a), Exchange Act section 10(b) and Advisers Act sections 206(1) and 206(2). The case is pending. See Lit. Rel. No. 24172 (June 20, 2018).

Offering fraud: SEC v. Texas Coastal Energy Company, LLC, Civil Action No. 3:18 –cv-01587 (N.D. Tx. Filed June 19, 2018) is an action which names the firm and its control person, Jeffery Gordon, as defendants. Beginning in early 2013 and continuing through late 2014, Defendants raised over $8 million from about 80 investors. Those investors, solicited through cold calls in which Mr. Gordon participated, and with offering materials he prepared, were induced to invest in an oil enterprise in which they were promised a share of the revenues. In the cold calls and offering materials the experience of the firm, its reserves and the prospects of a return were misrepresented. Defendants misappropriated a significant portion of the investor funds. The complaint alleges violations of Securities Act sections 5(a), 5(c) and 17(a) and Exchange Act sections 10(b) and 15(a). To resolve the action Defendants consented to the entry of permanent injunctions based on the sections cited in the complaint as well as to a conduct injunction prohibiting them from engaging in certain transactions regarding the purchase and sale of a security. They also agreed to pay disgorgement, prejudgment interest and civil penalties totaling $7.2 million. Mr. Gordon has offered to consent to the entry of a penny stock bar. See Lit. Rel. No. 24169 (June 19, 2018).

Market manipulation: SEC v. Dynkowski, Civil Action No. 1:09 – 361 (D. Del.) is a previously filed action in which the court entered a final judgment by consent as to Defendant Richard Bailey, a former officer of GH3 International, Inc. based on his role in a pump-and-dump manipulation. The manipulation generated over $700,000 in profits. The Court’s order imposed a permanent injunction prohibiting future violations of Exchange Act section 10(b) as well as Securities Act sections 5(a), 5(c) and 17(a). The order also barred Mr. Bailey from serving as an officer or director and from participating in a penny stock offering. Financial issues are reserved for subsequent determination. This concluded the Commission’s action. See Lit. Rel. No. 24167 (June 18, 2018).

Market manipulation: SEC v. Fiore, Civil Action No. 7:18-cv-05474 (S.D.N.Y. Filed June 18, 2018) centers on the manipulation of a penny stock which netted the promoter over $11 million. Defendant Joseph Fiore controls Berkshire Capital Management Company, Inc., a private equity firm, and Eat At Joe’s, Ltd., a/k/a SPYR, Inc., an issuer that files periodic reports with the Commission. Both firms are defendants. The scheme traces to a meeting in early 2011 involving Mr. Fiore and the CEO of publically traded Plandai Biotechnology, Inc., a firm based in London, England. The firm was supposedly in the business of producing botanical extracts from live plants, including marijuana. The meeting focused on promoting the shares of Plandai. The next year Mr. Fiore acquired beneficially 5.5 million shares of Plandai, supposedly as part of a merger transaction involving and another firm. By March 2013 an agreement had been struck pursuant to which Mr. Fiore would organize the promotion of Plandai. Mr. Fiore launched the campaign, which he funded and implemented, the next month. Over the next year a series of steps were taken to manipulate the share price of Plandai, including: 1) retaining two firms to promote the stock, urging investors to buy shares in alerts, research reports and emails; 2) purchasing stock to support the price; 3) engaging in wash and matched trades to create the appearance of market activity; 4) marking the close to push up the price at the end of the trading day; and 5) painting the tape by initiating multiple orders at about the same time to move the price. During the manipulation Mr. Fiore sold about 11.9 million shares of Plandai stock for proceeds of over $11 million. The complaint alleges violations of Securities Act section 17(a), Exchange Act sections 9(a)(1), 9(a)(2), 10(b), 13(d) and 20(a) and Investment Company Act Section 7(a). The case is pending. See Lit. Rel. No. 24171 (June 20, 2018).

Misappropriation: SEC v. Fossum, Civil Action No. 2:17-cv-01834 (W.D. Wash.) is a previously filed action against Ronald Fossum. The complaint alleged that Mr. Fossum misappropriated millions of dollars in investor funds raised through three unregistered offerings. The Court entered a final judgment by consent, permanently enjoining Mr. Fossum from future violations of Securities Act sections 5(a), 5(c) and 17(a) and Exchange Act sections 10(b), 15(a) and Advisers Act sections 206(1) and 206(2). The judgment also directs that Mr. Fossum pay disgorgement of $804,729, prejudgment interest of $110,923 and a penalty in the amount of $320,000. A conduct based provision of the injunction precludes Mr. Fossum from participating in the issuance, offer or sale of any security except for his own account. Mr. Fossum has also consented to the entry of an order barring him from the securities business and from participating in any penny stock offering in a related administrative proceeding. See Lit. Rel. No. 24166 (June 15, 2018).


Attempted manipulation: In the Matter of JPMorgan Chase Bank, N.A., CFTC Docket No. 18-15 (June 18, 2018) is an action against the bank for attempted market manipulation. Specifically over a five year period beginning in January 2007 Respondent attempted to manipulate the U.S. Dollar International Swaps and Derivatives Association Fix which is set each day at 11:00 a.m. Just prior to the fix the bank repeatedly took steps to try and push the price, a point recorded in emails. In some instances the bank also tried to push the price at the daily close. These facts were openly discussed. The Order alleges violations of sections 6(c)(1), 6(c)(1)(A), 6(c)(3), 6(d) and 9(a)(2) of the CEA. In resolving the action the bank took certain remedial steps and cooperated. To resolve the proceeding the bank consented to the entry of a cease and desist order based on the sections cited in the Order and agreed to pay a $65 million penalty.

Criminal Cases

Advanced fee scheme: U.S. v. Elrod, No. 1:15-cr-00001 (D. CO); U.S. v. Dawn, No. 1:15-00040 (D. CO). On June 19 and 20, 2018 defendants Brian Elrod and William Dawn were sentenced for their role in an advanced fee scheme. Defendant Elrod was the CEO of Compass Financial Solutions while Mr. Dawn was the general counsel. Each man pleaded guilty to one count of conspiracy to commit mail fraud and wire fraud. The pleas were based on a scheme that took place from 2005 to 2011. Promissory notes were marketed to investors who were supposed to obtain a high rate of return through monthly interest payments in return for an up -front fee. In fact the funds were misappropriated. There were about $2.5 million in investor losses. Mr. Elrod was sentenced to serve 38 months in prison followed by three years of supervised release. He was also ordered to pay restitution of $2,440,051.29. Mr. Elrod, 80, who assisted with the scheme, was sentenced to time served and ordered to pay restitution of $366,752.01.

Fraud: U.S. v. Holmes, No. 5:18-cr-00258 (N.D. CA. Unsealed June 15, 2018). The founder of Theranos, Inc., Elizabeth Holmes, and the firm’s COO, Ramesh Balwani, were each indicted on charges of conspiracy to commit wire fraud and nine counts of wire fraud. The charges are tied to two schemes, one to defraud consumers and physicians and a second investors, that took place between 2006 and 2016. Specifically, defendants repeatedly claimed that they had created a revolutionary blood testing machine when raising over $700 million of financing for the company. In fact the representations were false. See SEC v. Holmes, Civil Action No. 5:18-cv-01602 (N.D. Calif. Filed March 14, 2018); SEC v. Balwani, Civil Action No. 5:18-cv-01603 (N.D. Calif. Filed March 14, 2018).

Insider trading: U.S. v. Chang, No. L18-cr-00034 (N.D.CA.) is an action in which Peter Change, the founder and former CEO of Alliance Fiber Optics Products, Inc., a manufacturer of fiber optic components, previously pleaded guilty to insider trading and tender offer fraud. Specifically, Mr. Chang admitted that he sold AFO shares shortly prior to the earnings announcements for October 28, 2015 and February 18, 2016, permitting him to avoid losses. He also traded prior to the public announcement that the firm would be acquired in April 2016. The Court sentenced Mr. Change to serve 24 months in prison. He will be subject to three years of supervised release following the completion of the prison term. See also SEC v. Chang, Civil Action NO. 5:17-cv-05438 (N.D. CA.).


Violating suspension: A hearing panel imposed a permanent bar on broker Bruce Martin Zipper, formerly a principal at his firm, Dakota Securities, and expelled the firm. The orders were entered in view of the fact that Mr. Zipper violated the three month suspension imposed on him as part of an earlier settlement. The order as to the firm was for failure to supervise.

The post This Week In Securities Litigation (Week ending June 22, 2018) appeared first on SEC ACTIONS.

June 22, 2018
SCOTUS: SEC’s ALJ Appointment Process Unconstitutional
by John Jenkins

Yesterday, in Lucia v. SEC, the SCOTUS held that the SEC’s appointment process for its ALJs violated the Appointments Clause of the U.S. Constitution. As this excerpt from the opinion’s syllabus notes, the Court’s decision was based primarily on its earlier decision in Freytag v. Commissioner, 501 U. S. 868 (1991), which held that Tax Court “special trial judges” were “officers of the United States” for purposes of the Appointments Clause:

Freytag’s analysis decides this case. The Commission’s ALJs, like the Tax Court’s STJs, hold a continuing office established by law. SEC ALJs “receive[ ] a career appointment,” to a position created by statute. And they exercise the same “significant discretion” when carrying out the same “important functions” as STJs do. Both sets of officials have all the authority needed to ensure fair and orderly adversarial hearings – indeed, nearly all the tools of federal trial judges.

The Trump Administration’s decision to “switch sides” in this case & support the argument that the SEC’s ALJs were unconstitutionally appointed might suggest that the case was decided along partisan lines. But that’s not what happened.  Justice Kagan delivered the Court’s opinion, and the Chief Justice and Justices Thomas, Kennedy, Alito & Gorsuch joined in the opinion.  Justice Breyer also concurred – in part – in the Court’s decision. Justices Ginsburg, Sotomayor & Breyer (in part) dissented.

What About Prior ALJ Decisions?

As we’ve previously blogged, some have suggested that the decision to invalidate the SEC’s appointment process for its ALJs might call into question the validity of prior decisions.  The Lucia Supreme Court didn’t speak to that issue directly, but if you’re interested in reading tea leaves, check out this excerpt from Justice Kagan’s opinion:

This Court has held that “one who makes a timely challenge to the constitutional validity of the appointment of an officer who adjudicates his case” is entitled to relief. Ryder v. United States, 515 U. S. 177, 182–183 (1995). Lucia made just such a timely challenge: He contested the validity of Judge Elliot’s appointment before the Commission, and continued pressing that claim in the Court of Appeals and this Court.

That emphasis on a “timely challenge” suggests that parties who didn’t make a timely objection to the ALJ’s authority in their particular case may be out of luck if they try to challenge a decision now.  Or maybe not – look, I mostly played softball in law school, so don’t expect profound insights on SCOTUS opinions from me.

SEC to Consider Proposed Changes to “Smaller Reporting Company” Definition

According to this “Sunshine Act” notice, the SEC will consider adopting proposed amendments to the definition of the term “smaller reporting company” at an open meeting to be held next Thursday, June 28th. Other items of interest on the agenda include:

– Consideration of a proposed rule amendment that would mandate the use of “Inline XRBL” – which allows filers to embed XRBL data in filings – in operating company financial statement information and mutual fund risk/return summaries.

– Whether to propose amendments to the SEC’s whistleblower rules.

John Jenkins

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6/22/2018 posts

CLS Blue Sky Blog: Wachtell Lipton Discusses Shareholder Activism, Corporate Governance, and the Hunt for Long-Term Value
The Harvard Law School Forum on Corporate Governance and Financial Regulation: A Public Option for Bank Accounts (or Central Banking for All)
The Harvard Law School Forum on Corporate Governance and Financial Regulation: Gender Quotas on California Boards
SEC Actions Blog: This Week In Securities Litigation (Week ending June 22, 2018) Blog: SCOTUS: SEC’s ALJ Appointment Process Unconstitutional

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