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On April 5, 2017, the Securities and Exchange Commission (“SEC”) issued an Order (the “Order”) instituting Public Administrative and Cease-and-Desist Proceedings against Lawson Financial Corporation (“Lawson”) for failing to perform reasonable due diligence on bond underwritings for the renovation and development of senior living facilities. These bond offerings were made in connection with Atlanta-based business man Christopher F. Brogden (“Brogden”), who has been separately charged by the SEC and faces a court order to repay $85 million to investors. The SEC alleges that Lawson failed to protect investors from Brogden’s scheme by neglecting to ensure Brogden was in compliance with necessary disclosures, that under Sections 17(a)(2) and (3) of the Securities Act and Section 15(c)(2) of the Exchange Act and Rule 15c2-12 which require underwriters to receive annual financial and operating disclosures from any debt structured deal.

According to the SEC between 2010 and 2014, Lawson served as the underwriter for 13 separate Brogden bond offerings, through which approximately $87 million was raised. These funds were raised for the purpose of constructing, purchasing and renovating a variety of nursing homes, assisted living homes and senior development communities. While engaging in the underwriting of the bonds, Lawson failed to expose the persistent and continual material breaches, misrepresentations, and flouting of disclosure rules made by other Brogden-controlled companies. In addition to failing to uncover problems related to Brogden’s previous debt offerings, Lawson failed to perform its duties in obtaining annual financial disclosures from the projects underpinning Brogden’s bond offerings.

The SEC notes in its Order that by failing to continually obtain necessary financial disclosures while underwriting bonds for Brogden’s senior living development scheme, Lawson allowed the fraud to continue, thereby harming more investors. Andrew M. Calamari, Director of SEC’s Regional New York Office, stated: “Underwriters are critical gatekeepers relied upon by investors to ensure that accurate information is being provided in municipal bond offering documents.”

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There have been over 2,000 FINRA arbitrations filed in Puerto Rico in regards to unsuitable leveraged investments in Puerto Rican bond funds, and over $226 million in awards so far. However, many of these cases settle. Some analysts have noted that while banks such as UBS have faced a large number of arbitration claims for investing clients’ funds in unsuitable high-risk leveraged Puerto Rican bond funds, bank of Santander was spared from most of these claims and is subject to only 200 filings. This lower number of claims stands in contrast to the fact that the Santander funds had higher leverage than UBS, and may have been marketed more aggressively to unsuitable clients.

Santander sold over 12 closed end funds and six open end funds in Puerto Rico; designated “First Puerto Rico Funds.” Santander marketed 11 of these funds to clients with conservative investment goals of “capital preservation,” yet these funds declined by 56% on average. In 2013, there were $3.4 billion in assets in these 11 closed end funds. By 2015, there were only $1.6 billion, with $1.8 billion in valuation vanishing as default rates rose on the bonds.

Most municipal bond funds are leveraged at a maximum of 20%, whereas Santander sold Puerto Rican municipal bond funds to conservative investors leveraged at 50% – 100%, doubling potential gains, but also doubling possible losses. Given that Puerto Rican municipal bonds were already paying coupons of between 5% to 6%, leveraging an already-risky bond in which the inflated yield is supposed to compensate for increased risk is unwise at best, according to some investment professionals.

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Leading Plaintiffs Robert Colman (“Colman”) and Hillary Taubman-Dye (“Dye”) have filed a class action suit in the United States District Court for the Northern District of California against Theranos (“Theranos”) and founder Elizabeth Holmes (“Holmes”).  Theranos is a biotech company founded in 2003 on the premise of developing and producing cheap and rapid biomatter testing capabilities. It quickly became a highly sought after investment opportunity, rapidly reaching a nine-figure valuation, with investors predicting enormous demand for cheap, accurate, and portable home testing devices. However, it has since been the subject of numerous legal actions, both criminal and civil, alleging that its representations about an exclusive and proprietary blood testing technology were entirely fraudulent, and that no such revolutionary technology existed. Similarly, in their Complaint, Colman and Dye accuse Holmes of personally enriching herself while spinning a story that her revolutionary technology would both save millions of lives and cut costs: “the truth—there was no revolutionary technology” the Complaint alleges.

In its Answer, Theranos asserts that the Plaintiffs have no standing because they never invested directly in Theranos, rather they invested in venture capital firms, LVG XI and Celadon Technology Fund, which in turn invested in Theranos. Theranos further contends that Colman and Dye did not purchase fractionalized shares that would have given them traditional shareholder rights such as voting power or legal recourse. The analogy Theranos provides is that if an individual invested in an Exchange Traded Fund (“ETF”), and one of the companies in which that ETF had holdings committed fraud, the investor would have no grounds for claims against the company because the investor does not own the underlying securities, only rights to their collective valuation through the ETF.

The Plaintiffs argue that this analogy is misleading, given that the investments made in LVG XI and Celadon Technology Fund were placed exclusively for the opportunity of investing in Theranos, and that these venture capital firms are not at all similar to mutual funds or ETFs. Instead, they are vehicles for allowing investors to have access to private offerings of sought after companies, such as Theranos. The Plaintiffs further assert, these types of venture capital funds act more as an intermediary for investors who have the intention of investing in a specific company, yet lack the capital or connections to gain access to it–so use firms such as LVG XI or Celadon Technology Fund to facilitate this process. Plaintiffs are additionally seeking class action certification, as they believe there are many similarly situated individuals who incurred losses. The outcome of this case could set a precedent for future claims to arise in the venture capital and private offering sphere of the securities market.

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According to analysts, private “tech unicorns” (tech companies with a valuation over $1 billion) have been recently engaging in unusual stock buyback activity in the private markets. For example, Uber Technologies Inc., in a recent announcement, said “those who work at the San Francisco company for at least four years can sell as much as 10 percent of their shares.” This sale highlights two emerging themes in the securities market: (1) multinational companies are able to raise billions in the private markets from both institutional and retail investors without the need to go public; and (2) the function of going public for these companies that have raised capital in private offerings is primarily to return money to shareholders who bought stock in private offerings.

For many tech companies, a significant portion of employee pay is in the form of preferred stock, varying from 5% – 30% of overall compensation. As industry analysts note, Uber’s private stock buyback program will help them retain talent, as employees anxious for the company to go public so as to liquidate stock options will be able to realize some of their compensation more immediately. However, some experts are worried, because Uber appears to be profiting off of this buyback, due to differing liquidity expectations of the buyers and sellers, and the subsequent wide spread between the bid and ask of these private stock offerings.

Consequently, Uber can purchase common stock from employees for 25% – 30% less than what it has sold the stock for in recent funding rounds. Given that Uber is not publicly traded, employees who want to unload their stock have few options due to the limited liquidity, and can sell primarily only to Uber. Investors who want to purchase shares in Uber, which is a private company whose stock offerings are scarce, are willing to pay a premium because it is difficult to access the stock. In this scenario, Uber is profiting off the bid-ask spread between what employees are willing to sell the stock for, and what investors are willing to pay for it.

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On February 14, 2017, the Securities and Exchange Commission (“SEC”) instituted administrative and cease-and-desist proceedings pursuant to sections 203(e) and 203(k) of the Investment Advisors Act of 1940 (the “Order”), alleging that Morgan Stanley was responsible for the unsuitable solicitation and sale of inverse ETFs to clients.  Morgan Stanley has submitted a settlement Offer of $8 million (the “Offer”), and acknowledged wrongdoing in selling and marketing these inverse ETFs as a long-term investment strategy, when Morgan Stanley’s very own compliance policy procedures recommended such ETFs for only short term holds.

An ETF is a fund which owns underlying assets in a given sector (shares of a stock, bonds, foreign currency) and divides ownership of these assets into shares, which can be purchased by investors.  Investors do not have any direct claim to the underlying investments, but indirectly own them through the ETF shares.  ETFs can be sector specific (aerospace defense, semiconductors, uranium) or broad and track overall market performance.  According to the Order, the specific type of ETF Morgan Stanley was improperly selling to investors is an “inverse” ETF.  Nontraditional ETFs are generally inverse, leveraged, or inverse leveraged, although other more exotic types of ETFs such as different bundling’s of derivative options exist.  Inverse ETFs track an underlying package of securities; however, they are composed of various option derivatives that sell the underlying asset short.  This means that if the underlying assets go up, the inverse ETF goes down, and if the underlying assets go down in value, the inverse ETF rises in value.

Pursuant to FINRA Regulatory Notice 09-31, inverse ETFs are not suitable for long term holds for two reasons.  First, the most the ETF can appreciate is 100%, if all its underlying assets go to zero (highly improbable), whereas a long ETF can appreciate as much as its assets rise which could over the course of several decades lead to a doubling or tripling of your initial investment.  The second and most significant reason for why inverse ETFs are dangerous for a long-term hold, is that there is an underlying cost to hold them both in higher fees, and in inherent structural costs called “beta-slippage decay.”  The high fees associated with inverse ETFs, generally 1%, are due to the costs associated with purchasing “shorts,” or option derivatives on the underlying assets.  This makes inverse ETFs more expensive than regular ETFs, which simply purchase underlying assets rather than short options.  Beta-slippage decay is a mathematical term used to describe the costs associated with rebalancing on inverse or leveraged ETF.  In summary, if the underlying assets that the inverse ETF is pegged to do not change in valuation, the inverse ETF will slowly decline in value due to fees and rebalancing costs. This is why inverse ETFs are unsuitable for long term holding strategies, unless in rare cases they are part of a specific, documented hedging strategy where benefits outweigh these increased costs.

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On January 25, 2017, the Securities and Exchange Commission (“SEC”) instituted public administrative 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”), and Section 9(b) of the Investment Company Act of 1940 (“Investment Company Act”) (the “Order”) against New York based brokerage firm Windsor Street Capital LLP, formerly known as Meyers Associates LLP (“Meyers”), and its former anti-money laundering officer John D. Telfer (collectively , “Respondents”). These enforcement actions were brought on the accusation that Windsor failed to file suspicious activity reports (“SARS”) on approximately $24.6 million in dubious transactions, and thereby enabled two financiers to run a “pump and dump” scheme while earning approximately $493,000 in commissions from facilitating these illegal penny stock sales.

These financiers, Raymond H. Barton and William G. Goode, were separately charged by the SEC with a pump and dump scheme.   Barton and Goode are accused of buying shares of sparsely traded shell companies for purported dietary supplement businesses, hyping them in “news” releases, and then dumping the shares at inflated prices.

A “pump and dump” scheme is a form of fraudulent market manipulation, in which a company (generally small, so called “microcap” companies) are promoted through false and misleading statements and mischaracterizations, in order to inflate or deflate the price of their stock.  These false messages can be spread through social media platforms, chat rooms, newsletters, or telemarketer phone calls, and are generally perpetrated either by paid promoters or company insiders.  Once these insiders “dump” their shares, the price of the stock typically falls, and investors lose money.  The reverse of this strategy is when fraudsters purposely try to deflate the price of a stock through fraudulent actions, so as to buy it on the cheap, however this is a more unusual scenario.

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On January 25, 2017, the Securities and Exchange Commission (“SEC”) filed a complaint in the United States District Court for the District of Massachusetts against Michael J. Breton (“Breton”), and his investment advisory firm Strategic Capital Management (“SCM”), (collectively the “Defendants”) for engaging in “cherry-picking,” and defrauding investors of approximately $1.3 million in proceeds (the “Complaint”).  At all times during the fraud, Breton was under a fiduciary duty to SCM clients, and had made promises that his personal trading activities would not disadvantage SCM investor returns—statements that time proved to be misleading and false.  The Defendants actions violated several antifraud statutes and SEC rules, including Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b- 5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 (“Advisers Act”).

Cherry Picking occurs in many forms, but its basic structure is as follows. An investment advisor who is authorized to buy securities on behalf of investors purchases a stock, and then defrauds investors by waiting to see whether the stock goes up or down before allocating the trade to himself or his clients’ accounts depending on the profitability observed after the fact.  The Complaint notes that in this instance, Defendants allocated more than 200 unprofitable trades to client brokerage accounts, while allocating more than 200 profitable trades to Breton accounts, after their gains were realized.

SCM is a limited liability investment advisory firm, registered in Massachusetts since 2000. Breton founded SCM in 1999, and served as the Managing Partner and Chief Compliance officer of SCM. Breton used two different brokerage firms to place orders through.  According to the Complaint, Breton purchased securities through two master accounts, and they allocated these securities to various client accounts, or accounts he himself owned, depending on the profitability outcome of these trades.  The Complaint alleges that this fraudulent cherry picking activity began in January 2010, and continued through March 2016.  The Complaint notes that Breton would employ a familiar strategy of buying several stocks right before their earnings reports were released, then as soon as the earnings call was made, would immediately thereafter allocate winning stocks to his accounts, and stocks that missed earnings or revenue projections to his clients’ accounts.

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Twitter investors are bringing actions against the social media giant on grounds that employee compensation structuring has depressed stock values, slowed company growth, and incurred investors enormous losses.  This class action has been brought by investors Johnny Hosey (“Hosey”) and George Shillliare (“Shillaire”) (collectively, “Plaintiffs”).  The suit was filed in San Mateo County Superior Court, CA, taking aim against Twitter, its executives and several prominent investment banks.  The suit accuses the social media company of lying in its public disclosures when it went public in November 2013.  A company of Twitter’s size faces numerous suits on a regular basis, fielding a wide variety of complaints. This case is unique, however, in that it is a class action, and specifically addresses Twitter’s unusual employee compensation structures that claimants allege contributed to damages.

Plaintiffs allege that Twitter’s employee compensation package devalued the company through the following mechanism: employees were compensated largely with stock, with it representing a disproportionate percentage of their compensation package relative to other tech companies of Twitter’s size.  As Twitter stock fell, due to issues with user growth, ad monetization, and management uncertainty, Twitter’s stock fell.  As the stock fell, it became harder to retain or attract tech talent, given that the majority of compensation was stock based.  As talented managers left for better opportunities, stock price fell further, and the cycle repeated itself.  The complaint summarizes this mechanism as follows: “[u]ltimately a ‘death spiral’ ensues: departing employees weaken the company’s competitiveness; a less competitive company results in lower user growth which hurts the growth of advertising revenue; the company’s poor performance causes its stock price to fall; a falling stock price results in reduced compensation to current and prospective employees causing them to leave for better prospects, which in turn further weakens the company.”

Most litigation to date levied at Twitter allege poor stock performance due to actionable management negligence, or fraud in regard to user growth metrics being exaggerated, or stock decline due to the company’s inaction regarding user bullying leading to bad public relations.  This is the first suit of its kind from investors that specifically seeks damages in relation to management decisions regarding employee compensation.  The suit will likely cite findings and actions made in suits brought by Twitter employees themselves, who have sued their employer alleging they were misled as to how much stock growth would increase their compensation packages.  Twitter made its Initial Public Offering (“IPO”) November 2013 at $28 a share.  It is currently fluctuating between $14-18 a share.  By focusing on employee retention and compensation this lawsuit opens a new front in regards to analyzing Twitters problems.

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On December 19th, 2016 the Securities and Exchange Commission (“SEC”) filed a Complaint (the “Complaint”) against Defendants Platinum Management, LLC (“Platinum Management”), Platinum Credit Management, L.P.(“Platinum Credit”), Mark Nordlicht (“Nordlicht”), David Levy (“Levy”), Daniel Small (“Small”), Uri Landesman (“Landesman”), Joseph Mann (“Mann”), Joseph San Filippo (“San Filippo”) (collectively the “Platinum Defendants”), and Jeffrey Shulse (“Shulse”) (all collectively “Defendants”), charging Defendants with a complex, multi-pronged, fraudulent scheme to inflate returns to investors, and cover up massive losses and liquidity problems.

Prosecutors allege that Platinum Defendants collectively engaged in one of the largest investment frauds since Bernie Maddoff’s elaborate Ponzi scheme was uncovered in 2008.  On paper, Platinum Management averaged compound returns of 17% a year from 2003 to 2015, making it one of the best performing New York based hedge funds in the industry.  The Complaint draws question to Platinum Management’s 17% yearly return, given that many positions were fraudulently overvalued, and the fund engaged in heavy high interest short term borrowing to pay back costumer redemptions. The true performance of the hedge fund won’t be found out until the entire fund is liquidated and the SEC completes its investigation.

Platinum Management permitted more liquidity to investors then many of their competitors, permitting freedom to redeem funds on 60 or 90 days’ notice.  The firm heavily advertised this advantage; the capacity for the firm to rapidly liquidate positions.  The Complaint alleges that in reality, Platinum Management was facing an urgent liquidity crises, brought on by several large illiquid investments in oil production companies.  In as early as 2012, internal correspondence among Platinum Management officials spoke of fund redemptions that were “relentless,” and a “code red,” meanwhile continuing to conceal from current and prospective investors the precarious position of the fund.

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On December 28, 2016, Lax & Neville LLP, a leading national securities arbitration law firm, won a FINRA arbitration award on behalf of Anthony F. Garvin, a former investment banker at Burnham Securities, Inc.  The investment banker had brought claims for breach of contract, violation of the New York Labor Law, conversion, unjust enrichment, and quantum meruit against Burnham Securities, Inc. and David S. Gilio, a former investment banker at Burnham in connection with an investment banking fee.  Garvin and Gilio, with Burnham’s approval, agreed to collaborate on investment banking deals, and to share the commission for all deals that originated from their joint efforts, depending upon who sourced the respective deal.  When one deal closed, Garvin was not paid the full investment banking fee due to him.

A FINRA arbitration panel found Burnham and Gilio jointly and severally liable and ordered them to pay Garvin more than half a million dollars, including the full amount of compensatory damages he requested in the amount of $348,125 plus interest at the rate of 9% per annum from December 15, 2016 until the award is paid in full, pre-award interest in the amount of $121,352, costs totaling $5,721, and attorneys’ fees in the amount of $90,000.  “The Panel awarded attorneys’ fees as all parties requested attorneys’ fees.”  See Award.

Lax & Neville LLP has extensive experience representing investment bankers and financial services professionals in compensation disputes.   To discuss this arbitration award, please contact Barry R. Lax or Sandra P. Lahens, Esq., at (212) 696-1999.