The Supreme Court heard argument in a significant securities case this week. The question the High Court will resolve later this term is whether a securities law plaintiff relying on the fraud-on-the-market theory must, at the class certification stage, prove that the claimed misstatements were material. The district court and the Ninth Circuit held that the plaintiffs were not required to establish materiality at certification.
SEC Enforcement filed three actions this week. One centered on an offering fraud, a second is based on a market manipulation claim while the third involved an investment adviser concealing market crisis losses.
Remarks: Norm Champ, Director, Division of Investment Management, addressed the ALI CLE 2012 Conference on Life Insurance Products, Washington, D.C. (Nov. 1, 2012). His remarks reviewed the recent financial literacy study, the new investor advisory committee, a new risk based approach the Division will employ and product changes (here).
The Supreme Court
The Court heard arguments in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, Docket No. 11-1085. The question for resolution is whether a securities law plaintiff must demonstrate that the claimed misrepresentations are material at the class certification stage in a fraud-on-the-market case.
The resolution of this question is at the intersection of Rule 23, Federal Rules of Civil Procedure, and the Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988). The Rule governs class certification and in subsection (b)(3), central here, requires that the issues common to the class members predominate to permit the case to move forward as a class action. Basic held that a plaintiff can establish the element of reliance on the misrepresentations by utilizing a rebuttable presumption that purchasers relied on the integrity of the market if it is efficient so that a material misrepresentation would be reflected in the price. In essence, the presumption establishes transaction causation, linking the purchaser and the misrepresentation.
Three themes dominated the arguments. First, the critical point under Rule 23(b)(3) is whether the issues common to the class members predominate. When they do the class can be certified. The text of the Rule makes no reference to the merits of the claim. Second, Basic requires that the securities law plaintiff establish that the market is efficient and that the misrepresentation is material to employ its rebuttable presumption. If the misrepresentation is not material by definition it will not impact the market and there can be no presumption. Third, in earlier cases the High Court has hewed close to the text of Rule 23 when considering the class certification question, concluding that the plaintiff need not turn the certification hearing into a resolution of the merits.
Essentially Petitioners claimed that contrary to the ruling by the Ninth Circuit, at certification plaintiffs should be required to establish the materiality of the claimed false statements under Basic. Respondents and the government rejected this contention, arguing that under Rule 23 the issue is common questions among the class permitting certification while materiality is a merits issue.
SEC Enforcement: Filings and settlements
Statistics: This week the Commission filed 3 civil injunctive actions and no administrative proceedings (excluding tag-a-long and 12j actions).
Offering fraud: SEC v. McDuffie, Civil Action No. 1:12-cv-02939 (D. Colo. Filed Nov. 8, 2012) is an action against Stanley McDuffie and his controlled entity Jilapuhn, Inc. d/b/a Her Majesty’s Credit Union. Beginning in 2008 defendants used the website www.hmcu.net to lure investors to purchase certificates of deposits in what was claimed to be a credit union. The certificates were supposed to pay substantial interest and be guaranteed by Lloyd’s of London. In fact the CDs were fraudulent and the $532,000 of investor funds were put in a for profit company controlled by Mr. MCDuffie and misappropriated. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). The case is in litigation. See also Lit. Rel. No. 22526 (Nov. 8, 2012).
Manipulation: SEC v. Cole (S.D.N.Y. Filed Nov. 8, 2012) is an action against Lee Cole, Linden Boyne, Kevin Donovan and Timothy Quintanilla. Over a three year period beginning in 2006 Messrs. Cole and Boyne, serving as, respectively CEO and CFO, of Electronic Game Card, Inc. made misrepresentations regarding the financial condition of the company. They claimed, for example, that it had a bank account worth over $10 million, held investments worth millions of dollars and had significant annual revenues. In fact the bank account did not exist and the investments were in entities controlled by Messrs. Cole and Boyne. While making these misrepresentations the stock price soared. Messrs. Cole and Boyne funneled millions of shares off shore where they were sold. Throughout the period outside auditor Quintanilla issued unqualified audit opinions that falsely claimed to be in accord with PCAOB standards, according to the complaint. After much of the activity in the complaint concluded, Kevin Donovan became CEO of the company. He repeated the same false representations to investors while ignoring numerous red flags. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10A(a)(1), 10A(b)(1), 10(b), 13((a), 13(b)(2)(A), 13(b)(5), 13(d) and 16(a). The case is in litigation
Market crisis: SEC v. Morales (M.D. La. Filed Nov. 8, 2012) is an action against registered investment adviser Commonwealth Advisors, Inc. and Walter A. Morales, its founder and current sole-owner. Beginning in 2007 defendants engaged in a scheme to conceal huge losses suffered from holding residential mortgage-backed securities or RMBS. Those investments deteriorated in value as the market crisis unfolded. Rather that disclose the losses, Mr. Morales had the funds advised execute dozens of manipulative cross-trades which benefited some investors to the detriment of others in an effort to conceal the losses. When confronted by a large shareholder to whom Mr. Morales represented that the fund would not hold more that 10% of its assets in RMBS at a time when the concentration far exceeded that point, the investor was given false board minutes. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2) and 204 and 206(4). The case is in litigation.
Statement: Commissioner Bart Chilton issued a statement regarding the Commission’s Dodd-Frank rule making proposals. It states that the agency has finalized about two thirds of the required 60 rules and provides a list along with projected dates for the remaining work to be done (here).
Manipulation: The regulator expelled Hudson Valley Capital Management and barred its CEO, Mark Gillis from the securities business. In 2012 the firm, through Mr. Gillis, used its Average Price Account to improperly day trade millions of dollars of stock. Mr. Gillis manipulated the share price of those stocks and withdrew the proceeds. When there were losses he covered them by making unauthorized trades in customer accounts. Mr. Gillis also converted customer funds. The firm, which failed to supervise him, had a net capital deficiency of over $350,000 as a result of the scheme.
Investment fund fraud: The regulator brought a proceeding against WR Rice Financial Services and its owner, Joel Wilson to halt on-going sales activity and the conversion of investor funds. Investors were solicited by the firm, its owner and representatives to invest in land contracts on residential real estate in Michigan which carried an interest rate of 9.9%. In fact the firm and its owner diverted the funds to make unsecured loans to companies owned or controlled by Mr. Wilson. Investors were also not told that there was no ability to pay the loans when they came due. Mr. Wilson was also charged with providing fabricated documents to FINRA during its investigation and incomplete testimony. The proceeding will be scheduled for hearing.
Investment fund fraud: The SFO announced that city stockbroker David Andrew Levene was sentenced to serve 13 years in prison after pleading guilty to 12 counts of fraud, one count of false accounting and one count of obtaining a money transfer by deception. From April 2005 through October 2009 Mr. Levene solicited money from investors that was supposed to be invested in various securities. Instead he diverted the investor funds to his personal use. Over the period he raised about £250 million from investors. In part the money was used to repay investors which kept the scheme from being discovered for a period of time. In part it was diverted to pay for Mr. Levene’s personal expenses and travel. The scheme unraveled when investors brought suit to recover their money. Subsequently, Mr. Levene was made the subject of a bankruptcy order. Investor losses are estimated to be over £32 million.