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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 27, 2017, the Securities and Exchange Commission (“SEC”) charged Defendants Joseph Meli (“Meli”), Matthew Harriton (“Harriton”), 875 Holdings, LLC (“875 Holdings”), 127 Holdings, LLC (“127 Holdings”), Advance Entertainment, LLC (“Advance Entertainment”), and Advance Entertainment II, LLC (“Advancement Entertainment II”) (collectively, the “Defendants”) with perpetrating a fraudulent Ponzi scheme.  The SEC Complaint alleges that Defendants raised approximately $81 million from at least 125 investors for a purported purpose of buying large blocks of tickets to major events and concerts, specifically the Broadway hit musical “Hamilton,” and reselling tickets at a profit to generate high returns.  In actuality, the SEC alleges that Defendants operated a Ponzi scheme, making payments to prior investors using funds from new investors, while siphoning funds to support their lavish lifestyle, including jewelry purchases, private school tuition, luxury cars, and casino bets.  The Complaint charges Defendants with violating Section 17(a) of the Securities Act of 1933 (“Securities Act”) [15 U.S.C. § 77q(a)], and Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) [15 U.S.C. § 78j(b)] and Rule 10b-5 thereunder [17 C.F.R. § 340.10b-5]. See SEC Complaint.

According to the SEC Complaint, beginning in January 2015 through October 2016, Meli and Harriton solicited and collected funds for investments in 875 Holdings, 127 Holdings, Advance Entertainment, and Advance Entertainment II, entities all owned and controlled in various equities of ownership by Meli and Harriton.  Some investors invested in more than one entity, and the Complaint alleges it is unclear whether Meli and Harriton distinguished among the entities while making fraudulent representations to investors.

The entity “Advance Entertainment” specifically received over $50 million from investors and pursuant to a “Funding Agreement” signed jointly by Meli and an investor, Advance Entertainment made completely false representations to investors that there was an agreement in place with Hamilton’s Producers to purchase 35,000 tickets to the Broadway hit show and that the investors’ funds would be used to pay a portion of the cost of getting the tickets.  In fact, none of Meli or Harriton’s entities had any legitimate agreement with any Hamilton producers and all of the representations were false.

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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.

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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.