A federal judge in New York severely criticized the Securities and Exchange Commission over its handling of a lawsuit against Caledonian Bank Ltd., Caledonian Securities Ltd. (together, “Caledonian”) and others that resulted in Caledonian’s bankruptcy and liquidation.
According to the judge – the Hon. William H. Pauley III – the SEC initially filed a complaint against Caledonian, a bank and broker-dealer in the Cayman Islands, on February 6, 2015, in which it alleged that the defendants sold large quantities of worthless stock as principals (not agents for customers) without filing required registration statements with the agency. (Click here for a copy of the SEC complaint.)
After the SEC advised the Court that it had identified “recent transfers of funds” by Caledonian and another defendant – Verdmont Capital, S.A. – from certain of their US accounts, the court granted the agency’s application to freeze defendants’ assets. However, as soon as the following the day, noted the judge, counsel for Caledonian and Verdmont advised the SEC that each defendant had acted solely as a broker in the relevant transactions and not as a principal. This information was not shared with the court.
Unfortunately, a run on Caledonian began when news of the SEC’s allegations spread, “and panic ensued among depositors and investors,” said the judge. Within days, the Cayman Islands Monetary Authority placed both Caledonian entities into controllership and the bank began a process of voluntary liquidation.
It was not until May 2015, said the court, that the SEC advised it that Verdmont (and impliedly, Caledonian) had a far more limited role in the unlawful sales than previously described (Caledonian was no longer actively involved in the litigation by this time). Moreover, said the court, it turned out that other employees of the SEC – in other divisions and offices – had been aware that Verdmont had acted as a broker and not as a principal in the subject transactions at least five months prior to the filing of the SEC’s initial complaint. Unfortunately, the SEC attorneys involved in this action did not learn of this fact until the week of February 16, 2015, observed the judge.
Ultimately, the SEC filed an amended complaint that “blunted many of the harshest and categorical allegations in the original Complaint,” wrote the judge, “[b]ut here, the SEC’s failure to coordinate spawned more dire consequences than administrative inefficiency.” Caledonian was forced to liquidate.
The court criticized the SEC's investigation that prompted it to apply for the initial asset freeze order:
[t]he declarations submitted in connection with the SEC's motion to amend reveal an apparent failure to pose the appropriate inquiries to financial institutions before seeking crippling ex parte asset freezes. Prior to filing this action, the SEC asserted it had been "in frequent contact" with the legal departments of the U.S. financial institutions against whom it sought to enforce the asset freeze... However, it is not clear what questions the SEC asked to ascertain whether these assets belonged to the defendants – like Verdmont or Caledonian Bank – as opposed to their customers.
The court urged the SEC to self-reflect on its prosecution of this case and apply lessons-learned going forward:
[i]t is hard for this Court to believe that the SEC does not have systems in place to ensure that enforcement and regulatory staff are aware of investigations with common facts or the same individuals or entities … Given the high stakes in securities enforcement actions, and in the face of the workload the SEC describes as an “overwhelming burden,” a self-examination may be appropriate.
Judge Pauley’s commentary regarding Caledonian constituted the major portion of his 32-page ruling on a motion by Verdmont to summarily decide against the SEC in connection with its amended complaint. The court ruled such application was premature at this point.
My View: Sadly, this is not the first time over-zealous regulators have improperly caused the destruction of a company. After Arthur Andersen LLP – one of the top accounting firms of its time – was found guilty of obstruction of justice in 2002, following charges that it wrongfully destroyed documents in anticipation of an investigation by the Securities and Exchange Commission related to its dealings with Enron Corporation, the company gave up its licenses as certified public accountants and ceased conducting business. However, three years later, the US Supreme Court, in a unanimous verdict, overturned the firm's conviction (click here to access the Supreme Court decision). Unfortunately, the damage to Arthur Andersen was already too late to reverse, including the loss of jobs by 85,000 persons. As Judge Pauley pointed out in his decision in response to Verdmont Capital's motion, "the SEC's cannon of ethics cautions: 'The power to investigate carries with it the power to defame and destroy'." These are important principles that all regulators must consider before they pursue extraordinary relief against any corporation or individual.