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The Securities and Exchange Commission (“SEC”) issued public administrative and cease-and-desist proceedings pursuant to Section 8A of the Securities Act of 1933 (“Securities Act”) and Sections 15(b) and 21C of the Securities Exchange Act of 1934 (“Exchange Act”) (the “Order”) against EZTD Inc. (“EZTD”).  Israeli-based EZTD, a brokerage firm, offers binary options to US customers.  According to the Order, EZTD sold securities while not regulated to do so and made certain misleading or materially false statements on its subsidiary websites “eztrader” and “globaloption” regarding the profitability and risks associated with investing in binary options.

The Order states that EZTD willfully violated Sections 5(a) and 5(c) of the Securities Act and Section 15(a)(1) of the Exchange Act, and Sections 17(a)(2) of the Securities Act.  The charges brought by the SEC against EZTD relate to EZTD (1) selling securities over the internet without registering the securities, (2) failing to register as a broker-dealer while selling securities, and (3) misleading investors by failing to disclose that there was a significantly greater potential for investors to lose money than to turn a profit.  Additionally, the Order notes that only 2.8% of EZTD’s customers turned any kind of profit and EZTD misstated or omitted the true financial risks associated with investing in the firm’s binary options.

Binary options are derivatives, meaning that they are not actually bought or sold as an asset themselves, but rather are a fixed wager on the outcome of an underlying security.  Usually this bet takes the form of a wager on whether or not the price of an asset will rise or fall below a specified price by the time the binary option expires.  Winnings are predetermined, usually 80% of the initial bet, and losses generally result in forfeiture of the entire bet.  The time frame for these binary option derivative trades is short, with many of the options offered allowing 60 second time frame wagers.  A binary option does not give the owner the right to purchase or sell the underlying asset upon which the binary option is contingent, or to purchase or sell the binary option itself.

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On October 20, 2016, the Securities and Exchange Commission (“SEC”) instituted cease-and-desist proceedings pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”), against FMC Technologies, Inc. (“FMCTI”), Jeffrey Favret, CPA (“Favret”) and Steven K. Croft, CPA (“Croft”) (collectively, “Respondents”) and additionally instituted public administrative proceedings against Favret and Croft pursuant to Section 4C of the Exchange Act and Rule 102(e)(1)(iii) of the Commissions’ Rules of Practice (SEC actions collectively the “Order”).  The Order alleges that the violation of Generally Accepted Accounting Practices (“GAAP”) occurred in relation to manipulation of funds that were earmarked for FMCTI’s paid time off policies (“PTO”).  FMCTI agreed to pay a penalty of $2.5 million in relation to the SEC charges, and Favret and Croft agreed to pay $30,000 and $10,000, respectively.

FMCTI is an operations and equipment provider to the energy industry, designing and manufacturing service systems and products such as: offshore production and processing systems, surface wellhead systems; high pressure pumps and fluid control equipment; measurement solutions and marine loading systems for the oil and gas industry.  FMCTI is a Fortune 500 company that trades on the New York Stock Exchange, and its capabilities are divided into three business reporting segments: Subsea Technologies; Surface Technologies; and Energy Infrastructure.  Favret was the controller at Energy Infrastructure, and Croft was the controller of Automation & Control (“A&C”), a business unit that was acquired by Energy Infrastructure.  After the acquisition, Favret became segment controller and Croft became business unit controller.

The Order noted that FMCTI has an unusual PTO policy, with employees earning their PTO days on January 1 of each new year, rather than accruing them by month or pay period.  For example, if twelve (12) days of PTO are provided per year at FMCTI, an employee could conceivably take off the first twelve (12) days of January, leaving no remaining PTO days for the rest of the year.  The Order acknowledged that FMCTI structured its PTO policy to benefit employees as it gave them flexibility to use their PTO days in chunks. Unfortunately, it created a larger capital requirement to be held at the beginning of each calendar year.  Because, according to GAAP standards, FMCTI was required to establish a reserve for its full-year PTO liabilities as of January 1.  FMCTI also allowed employees to roll over unused PTO days from one year to the next.  Funds to pay these days were also required to be held in the account in addition to full year PTO liabilities.

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On October 16, 2016, the Securities and Exchange Commission (“SEC”) instituted cease-and-desist proceedings (the “Order”) against mobile phone application (“App”) Forcerank LLC (“Forcerank”) pursuant to violations of Section 8A of the Securities Act of 1933, and Section 21C of the Securities Exchange Act of 1934.  In response to the Order, Forcerank has submitted an Offer of Settlement (the “Offer”), without admitting or denying any wrongdoing but accepting SEC jurisdiction over regulation.

According to the Order, Forcerank is an App that allows users to attempt to predict the outcome of a basket of securities by ranking these securities based on their performance relative to each other.  While this usage may have functioned as a “game,” it was in essence an over-the-counter derivative trade: a payout was to be made not on the underlying value of any of these securities, but on a “derivative of” their value, in this case their value relative to each other.  The SEC alleges Forcerank structured the game in week-long segments, during which time players won points for each security for which they guessed the price.  Based on the accuracy of their prediction, at the end of the competition players who were most accurate received cash prizes.  Forcerank kept 10% of the entry fees, and maintained a data set of user behavior and bets that it intended to sell to hedge funds or other wealth managers as insight into crowd perception of certain securities.  Forcerank was a creation of Estimize, a private New York based company that collects and sells data about securities and trading, primarily through developing websites and Apps through which it can crowdsource user behavior.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) specifically regulates the derivatives market.  Whether or not the creators of Forcerank were aware that their product constituted a financial derivative is not material to the fact that they were required to file an effective registration statement covering their derivative offering with the SEC.  Given that Dodd-Frank requires that derivative type transactions occur only on exchanges, subject to the highest level of regulation and cleared with registered clearing agencies, so that investors are provided with public price discovery mechanisms, it is unlikely Forcerank would be able to operate its “swap” trading game even if it had registered properly.  Pursuant to reforms under Dodd-Frank that sought to limit the sale of security-based swaps, entities that are not “eligible contract participants” may not engage in this type of derivative trading.  In order to qualify as an “eligible contract participant,” among many categories required are monetary thresholds, mandating that an individual need to have at least $5 million invested on a discretionary basis to qualify as a seller of security-based swaps.

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On April 6, 2016, the Department of Labor (“DOL”) issued its final rule expanding the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (“ERISA”).  The rule, which is effective April 10, 2017, has already had significant impact on the wealth management business and advisers should be particularly aware of changes to recruitment and compensation.

The rule modifies the Best Interest Contract Exemption (“BIC”), under which the DOL permits financial advisers and their firms to engage in otherwise prohibited transactions.  When the rule was issued last year, many firms were concerned that the revised BIC would create unacceptable liability risk on commission-based retirement accounts and prohibit back-end performance-based incentives altogether.  The DOL has now confirmed that the back-end incentives, such as bonuses for meeting asset or sales targets, will no longer be exempted under the BIC.

On October 27, the Department issued a FAQ regarding the new rule.  Question 12 addressed recruitment incentives:

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On September 29th, 2016 the Securities and Exchange Commission (“SEC”) announced that International Game Technology (“IGT”), a casino-gaming company, would pay a penalty of $500,000 for dismissing an employee (the “Whistleblower”) who raised questions about its cost accounting model. The SEC alleges this termination occurred as retaliation for the Whistleblower investigating company accounting practices (the “Complaint”).  This case is the first stand-alone whistleblower retaliation case without charges of other misconduct.   On further investigation it was revealed that IGT did conform to Generally Accepted Accounting Practices (“GAAP”) and was not engaging in any illegal activities. However, IGT is being fined for violating whistleblower retaliation provisions in Section 21F(h) of the Securities Exchange Act of 1934 (the “Exchange Act”).  This fine was submitted pursuant to an Offer of Settlement (the “Offer”), without admitting or denying the findings contained within the Complaint.

The SEC protects whistleblowers from retaliation by their employers.  The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), which became effective in July 2010, contains new whistleblower provisions that provide substantial incentives and protections for individuals who voluntarily provide information to the SEC concerning securities law violations.  Securities violations that can be reported by whistleblowers to the SEC include the following: unregistered offer or sale of securities; insider trading; market manipulation; theft or misappropriation of funds or securities; bribery of foreign officials; filing false or misleading SEC reports or financial statements; Ponzi schemes; abusive naked short selling; fraudulent conduct associated with municipal securities transactions or public pension plans; and other fraudulent conduct.

IGT is a Nevada based corporation that is a subsidiary of IGT PLC, which is a public limited company that trades on the New York Stock Exchange (“NYSE”) as a foreign private issuer.  The Whistleblower joined IGT in 2008, and prior to his termination on October 30, 2014, had been promoted to the position of Director, overseeing a budget exceeding $700 million.  The Whistleblower was given only positive performance reviews during that time period, and his bonuses were in the highest range allowed for someone of his seniority.  According to the Complaint, the Whistleblower’s supervisors had put him at the top of their “talent planning matrix,” with the potential to be promoted to a vice-president role.

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On October 18, 2016, the Securities and Exchange Commission (“SEC”) issued cease-and-desist proceedings pursuant to Section 8A of the Securities Act of 1933 (“Securities Act”), Sections 15(b), and 21C of the Securities Exchange Act of 1934 (“Exchange Act”), Section 203(f) of the Investment Advisors Act of 1940 (“Advisors Act”), and Section 9(b) of the Investment Company Act of 1940 (“Investment Company Act”) against Paul T. Lebel.  Mr. Lebel was a broker and former representative of registered broker-dealer and investment advisor, LPL Financial LLC (“LPL”).  The Order alleges that Mr. Lebel churned client accounts by purposely and excessively trading mutual fund shares and other class A shares that carry large front-end load fees and therefore generate large commissions.  Such shares are intended to be part of a buy and hold strategy, and not traded at a high frequency.  Mr. Lebel has submitted an Offer of Settlement (the “Offer”), in response to the SEC issuance and the SEC has accepted and granted terms for this offer.

Churning occurs when, in pursuit of commissions, a broker causes securities in a customer’s account to be traded at a frequency that does not reflect the customer’s best interest or financial needs. There are three components necessary for a churning ruling to be established: (1) is broker control of trading activity either through direct written trade placement, or through de facto discretionary authority (i.e. the broker recommends to the client which trades to make and the client regularly agreed to every trade recommended); (2) the broker engaged in excessive trading contrary to client investment objectives and risk tolerances; (3) the broker acted with scienter in that he or she willfully engaged in this trading activity with reckless disregard for costumer interests, usually in pursuit of commissions.

A frequent statistical test used in determining whether churning has occurred on an account is the “turnover ratio.”  The turnover ratio is the ratio of the total cost of security purchases made relative to the average monthly dollar amount in the account.  While courts have not defined a specific ratio that constitutes churning, for example, any ratio over six (6) is considered excessive trading, and in conjunction with other evidence such as broker scienter can be grounds for a churning claim.  Another tool used to measure churning is the ‘break-even’ metric: the amount an investment would have to earn in returns in order to cover the fees of placing it.  If an investment has to appreciate by more than 8% to cover fees it is considered excessive trading.  If it has to appreciate by more than 12%, the metric is conclusive evidence of churning.  In summary, if trading transaction costs are high enough that there is little reasonable expectation that the account could achieve a consistent positive rate of return, the broker must justify the trading conducted.  Additionally, while damages on churning are limited to commissions and interest, a plaintiff can bring a claim regarding the suitability of investments (which is often applicable in churning cases, given that brokers will trade whatever securities earn them the highest commissions rather than what suits the financial needs of their client) and additional damages related to trading losses may be awarded.

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According to metrics provided by the Financial Industry Regulatory Authority (“FINRA”), $62.1 million of investor awards issued in 2013 went unpaid, due to brokerage houses’ insolvency.  The Public Investors Arbitration Bar Association (“PIABA”) analyzed FINRA arbitration outcomes and found that for every 1 out of 3 cases that yield damages in arbitration, those damages fail to be collected.  Brokerage firms that are insufficiently capitalized, if not outright insolvent, fail to have the resources to pay investors’ damages when sales practice violations or fraud are uncovered.  For investors who feel they may be victims of fraudulent activity, the additional risk of uncollectable damages is increasingly imbedded into their calculation of whether litigation would lead to a win and net financially positive results.

The Center for Financial Services Innovation (“CFSI”) is a wealth management industry support group, with members such as Bank of America, Charles Schwab, Morgan Stanley, and many smaller broker dealers.  CFSI routinely releases marketing statements with direct encouragements for investors to maintain financial health, as well as a safety net and large cushion of savings. CFSI releases metrics on consumer saving habits, showing that a small unexpected expense would cause bankruptcy for a large percentage of Americans.  Yet many CFSI members often fail to ensure that they can cover investor claims themselves.

In 2010, Securities America, was the fifth largest independent brokerage firm in the country with over 1,900 brokers employed.  However, it had a capital reserve requirement of only $250,000.  Given the limited capacity of its insurance, it had hardly any capital on hand to cover additional uninsured claims.  When Securities America sold $400 million worth of private placements which turned out to be Ponzi schemes that subsequently defaulted, it did not have the resources on hand to pay out damages stemming from various awards.  The claims were eventually settled by Securities America’s parent company Ameriprise.  In many instances, low capital reserves and insufficient insurance can be an advantage because it allows for bargaining from a position of weakness.  If engaged in a class action suit, Securities America can threaten to file for bankruptcy and declare themselves insolvent if claimants don’t agree to accept a specific sum of damages.  However, this case illustrates the underlying danger of the broker dealer industry–firms are far more concerned with paying out commissions and keeping the lights on than provisioning for damages owed to investors.

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On September 27, 2016, the Securities and Exchange Commission (“SEC”) filed a complaint against oil services company Weatherford International PLC (“Weatherford”), consequently garnering a $140 million settlement related to fraudulent income tax accounting (the “Complaint”).  According to the Complaint, Weatherford issued false financial statements between 2007-2012 inflating earnings by more than $900 million.  Weatherford misrepresented both its earnings per share (“EPS”), and effective tax rate (“ETR”), and created a misperception for investors that a unique tax structure had been designed which provided it with a superior international tax avoidance strategy, when no such advantages existed.  James Hudgins (“Hudgins”), Weatherford’s Vice President of Tax and Darryl Kitay (“Kitay”), Weatherford’s Tax Manager (collectively the “Defendants”) have agreed to settle charges that they orchestrated this fraud. Weatherford’s market cap is currently $5.04 billion, with the $140 million fine representing 2.7% of total valuation.

Weathorford is charged with: violation of Securities Act Section 17(a) and the Securities and Exchange Act of 1934 (the “Exchange Act”) Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B), and Rules 10b-5, 12b-20, 13a-1, 13a-11, and 13a-13 thereunder.  Defendant Hudgins is charged with: (i) willfully violating Securities Act Section 17(a), Exchange Act Sections 10(b), and 13(b)(5) and Rules 10b-5(a) and (c), 13b2-1 and 13b2-2 disseminated thereunder; (ii) orchestrating Weatherford’s violations of Securities Act Section 17(a), Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and (B), and Rules 10b-5, 12b-20, 13a-1, 13a-11, and 13a-13 promulgated thereunder; and (iii) willfully violating federal securities laws pursuant to Section 4C of the Exchange Act and Rule 102(e)(1)(iii) of the Commission’s Rules of Practice. Defendant Kitay, due to his fraudulent conduct, faces charges of: (i) willfully violating Securities Act Section 17(a), Exchange Act Sections 10(b) and 13(b)(5), and Rules 10b-5(a) and (c), 13b2-1 promulgated thereunder; (ii) instigating Weatherford’s violations of Securities Act Section 17(a), Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and (B), and Rules 10b-5, 12b-20, 13a-1, 13a- 11, and 13a-13 promulgated thereunder; and (iii) willfully violating the federal securities laws pursuant to Section 4C of the Exchange Act and Rule 102(e)(1)(iii) of the Commission’s Rules of Practice.

Weatherford was formed in 1998 with the merger of two companies, and immediately embarked on a strategy of aggressive expansion.  This directive was achieved largely through hundreds of acquisitions of smaller natural gas equipment and service providers, purchases that Weatherford financed by issuing corporate bonds.  The SEC alleges that this unchecked growth was largely responsible for the lack of effective internal controls governing income tax accounting.  In 2002, Weatherford completed an inversion to become incorporated in Bermuda, in order to be headquartered in a place of 0% tax jurisdiction.  From 2003 through 2006, Weatherford continued to embark on ETR reduction strategies through tax hybridization schemes, including shifting debt assets to high tax jurisdictions such as the US and Canada, and equity assets to low or zero tax jurisdictions.  These strategies reduced Weatherford’s ETR from 36.3% in 2001 to 25.9% in 2006.  Each percentage point reduction in Weatherford’s ETR translated to an approximately $0.02 to $0.03 gain in Weatherford’s EPS, giving the company more latitude to issue debt and make more acquisitions to increase revenue.

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On September 26th, 2016, the Securities and Exchange Commission (“SEC”) filed a Complaint for Injunctive and Other Relief against Craig V. Sizer (“Sizer”) and Miguel Mesa (“Mesa”) (collectively referred to as the “Defendants”), for violating federal securities laws (the “complaint”).  The Defendants specifically violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 (“the Exchange Act”), Rule 10b-5 thereunder, and Section 15(a) of the Exchange Act.  The Complaint alleges that the Defendants broke these antifraud and broker-dealer registration laws by deceiving over 600 investors of approximately $20 million and misappropriating the vast majority of these funds for personal use.

According to the Complaint, beginning in 2009 and continuing through August 2015, Sizer, former co-founder and former Chief Executive Officer of Sanomedics Inc. (“Sanomedics”) and former President and Board Director of Fun Cool Free Inc. (“Fun Free Cool”) (collectively referred to as the “Companies”), orchestrated the fraudulent sale of shares in both Companies.  This fraud involved equipping sales agents with materially misleading statements in relation to how investor capital would be spent.  According to the Complaint, Sizer hired Mesa to market these companies to investors.  Mesa oversaw boiler-room operations for sales agents, and provided them with scripts used to cold call prospective investors and fraudulently convince them to purchase shares in Sanomedics and Fun Cool Free.

The Complaint alleges, Sizer and Mesa used these tactics on many elderly, and financially illiterate investors.  They hired and directed Seven (7) or more sales agents, who purchased lists of contact numbers for individuals they believed possessed resources to invest, such as those who recently inherited sums of money.  Mesa told these sales agents that they did not need to be registered in order to sell stock.  These agents sold restricted stock to investors, ranging in prices from $0.05-$2.50 per share, while promising them outlandish profits and making untrue statements that they were buying the stock at a discount to the market.  Investors were also told that no fee or commission would be charged, while in actuality, Mesa paid 15-20% of the funds he misappropriated to the sales agents in the form of commissions.  Sizer was not, and never has been, registered as a broker despite courting investors personally.  Additionally, in 2004 and 2006 Mesa was charged in separate civil injunctive actions by the Commodities Futures Trading Commission (“CFTC”) for fraudulent activity in relation to trading futures and contracts. He was permanently barred from the commodities industry.  Both currently and during the relevant time period, Mesa was not registered as a broker or associated with a broker-dealer.

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On September 28th, 2016, the Securities and Exchange Commission (“SEC”) charged a Peruvian brokerage firm manager and two lawyers with making trades that were informed by insider knowledge regarding the imminent merger of two mining companies (“The Complaint”).  The SEC alleges that the Defendants Nino Coppero del Valle (“Valle”) and Julio Antonio Castro Roca (“Roca”) (collectively the “Defendants”) conspired to trade on information regarding the tender offer that Canadian-based Hudbay Minerals (“Hudbay”) made to acquire shares of Arizona-based Augusta Resource Corp. (“Augusta”).  The Complaint charges the Defendants with violating the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 (“The Exchange Act”).   In addition, Valle, Roca, and broker affiliate Ricardo Carrion (“Carrion”) are charged with violating clauses regarding a stay on trading ahead of the announcement of a tender offer contained in Exchange Act Section 14(e) and Rule 14e-3.

Valle was an attorney at Hudbay who was privy to the acquisition, and relayed this knowledge to his close friend and fellow attorney Roca, who then allegedly acted on this information by making trades through a brokerage account he set up in the British Virgin Islands.  This account was allegedly registered offshore in order to avoid regulatory scrutiny about the timing of the trades and their connection to insiders.  The Complaint alleges that these unlawful trades netted Valle and Roca over $112,000 in illegal profits.

While researching how to make trades untraceable, Valle allegedly sourced an acquaintance Carrion—an employee at a Peruvian brokerage House—and gave him insider information in exchange for advice on obscuring the trades that his friend Roca intended to make.  Carrion’s brokerage house made a profit of $73,000 off of the insider information that Hudbay was intending to acquire a large percentage of Augusta and its operations.  In a warning to others and a reference to the SEC’s cross border enforcement powers, Andrew M. Calamari, Director of the SEC’s New York Regional Office, told the press: “[T]ry as they might, overseas traders shouldn’t presume they can cover their tracks to avoid detection and scrutiny from U.S. law enforcement when they violate insider trading laws.”