Gatekeepers For Preventing Fraud: Educated Investors

The halting of another offering fraud on Friday by the SEC has, unfortunately, become routine. Offering frauds in which promoters take the hard earned dollars of investors and give them rosy dreams and worthless pieces of paper are all to common, particularly those conducted by securities law recidivists. The SEC’s most recent case in this area is a good example. There the years long scheme was conducted by two men with a history of securities law violations. Indeed, one had been barred by FINRA. Yet in the eight year history of the offering apparently nobody discovered that those selling the securities were scofflaws. SEC v. Brennan, Civil Action No. 1:16-cv-00307 (E.D. Tenn. Filed July 20, 2016).

The offering fraud conducted by Defendant James Brennan, with the aid of codefendants Douglas Dyer and Broad Street Ventures, LLC, is straight forward. Beginning in 2008 Messrs. Brennan and Dyer, through Broad Street, continuously offered shares of stock in eight separate but similar companies known as Scenic City F101, Inc. through Scenic City F10 VIII, Inc. Each investment was apportioned equally among the Scenic City Companies.

The Scenic City offerings were for blank check or shell companies that were to merge with a small, private firm that wanted to go public. A Form 10 registration statement was supposed to be filed with the SEC. The shares would be traded in the over-the-counter market. Total amount to be raised in the offering was $800,000. In the end each merged entity would be worth about $20 million and the shares would initially trade at about $1.00 per share. Collectively the transactions would give investors a return of over 800%.

Solicitations were built an a number of misrepresentations, including:

Registration: A Form 10 registration statement would be filed; over the eight years of the offering no such statement was filed;

Number of shares: While investors were told that only 2.2 million shares would be outstanding for each entity for a total of 17.6 million, in fact over 45 million shares were sold, averaging 5.6 million per entity;

Use of proceeds: The offering proceed were supposed to be used to implement the transactions, not diverted in large part to the personal use of the individual defendants.

Finally, and perhaps most importantly, the individual defendants touted their years of experience in the securities business, undoubtedly to win trust. What they did not disclose – and what apparently no investor discovered – is the regulatory history of Messrs. Brennan and Dyer. Mr. Brennan was the subject of multiple FINRA claims centered on failing to supervise retail trades by Mr. Dyer where excessive mark-downs were taken and unauthorized and unsuitable trading conducted in a customer account. The FINRA claims were settled with a consent decree that barred him from association with any member and the payment of a penalty. Mr. Dyer has also been sanctioned and suspended by FINRA for purchasing stock for retail customers at excessive mark-down and engaging in unauthorized trading. In addition, the California Department of Corporation also brought a cease and desist action against Messrs. Brennan, Dyer and their company for the unauthorized sale of securities. A similar action was brought against the two men by the Tennessee Securities Division. Overall about $5 million was raised from over 240 investors, according to the complaint.

The Commission’s complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). A freeze order has been obtained by the Commission. The case is pending.

This case, as well as other recent offering fraud actions brought by the SEC, highlights the need for vigilance by investors and additional investor education by regulators. The SEC, FINRA and state securities agencies work hard at uncovering and halting these fraudulent actions. As this this case illustrates however, often they arrive far to late by which time much of the investor money is gone.

It is unrealistic to expect that that regulators can stop or even fret out all of these cases. Halting them begins with skeptical investors who should look at over the moon promises of 800% returns with skepticism. They should research the background of those to whom they entrust their money. In this day of “everything is on-line” investors should be able to conduct a basic search on those asking for their money before handing it over. In this case, as with others where recidivists are involved, a basic internet search should have been the end of the potential fraud.

This is not to say that regulators need not step-up their efforts. While the SEC and others take steps to educate investors, it is clear that more needs to be done. Cases such as this, involving a very high risk investment in a “blank check” company promising more than hard to believe returns made by scofflaws, more than illustrates this need. It is time for regulators to increase their efforts in this critical area since the educated investor is often the first and most effective “gatekeeper” for preventing fraud.