This Week In Securities Litigation (Week of November 14, 2022)
This past week FTX filed for bankruptcy. While the second largest crypto exchange may have thought it couldn’t get worse, it did. FTX has discovered a hack that may have resulted in a large loss, according to the Washington Post. SEC Chair Gensler also continued to insist that crypto platforms voluntarily submit to regulation.
Be careful, be safe this week
SEC Enforcement – Litigated actions
Crypto-security: SEC v. LBRY, Inc., Civil Action No. 1:21-cv-00260 (D.N.H.). Defendant LBRY, Inc. is a privately owned firm based in Manchester, New Hampshire. It was created in 2015 to distribute digital content. The company began with video distribution as a possible competitor for YouTube, Amazon and other video platforms.
To move forward with its vision, LBRY claimed it would use blockchain technology by: 1) creating a “protocol” or set of rules for the transfer of data between devices; 2) create a user application; 3) make the necessary software to enable the protocol; 4) recruit those necessary for the video; and 5) attract consumers. To support these efforts the firm proposed to sell LBC – LBRY Credits. The financing effort began in March 2016 with an announcement on the company website about the program.
By June 2016 the firm launched its protocol having designed the first 400 million LBC in its possession. This constituted 40% of the total allowable supply under the protocol. The LBC were then divided into three funds: The Operational Fund; the Community Fund; and the Institutional fund. Each fund was used slightly differently to achieve the overall goal. For example, the Community Fund focused on consumers; the Institutional Fund looked to institutions for partnerships, grants, donations and similar matters; and the Operational Fund looked to profit. Beginning in 2016 the company offered LBC from the Community Fund in exchange for contributions to the network. At various points over a three-year period, beginning in 2017, LBC from each of the other funds were offered to investors. Those investors purchased LBC in return for U.S. currency, bitcoin or other consideration such as services. The reason for the purchase was an expectation of profits from the pooling of their funds with others. The profits would come from the efforts of Defendant.
Following these transactions LBRY continued to sell LBC. About 10 million LBC were sold to retail investors. In late June the firm took steps to stabilize the price of LBC which varied significantly. In October 2020 the company represented on its website that LBC will only gain value as the use of its Network increased. Efforts to deliver on the promises made to investors continued in March 2021. The LBC are not registered with the Commission. The complaint alleges violations of Securities Act Sections 5(a) and 5(c).
In moving for summary judgement the Commission relied on the test from SEC v. Howey, 328 U.S. 293 (1946). Its papers alleged that about $12.2 million in U.S. dollars and crypto assets had been raised from the sale of the assets. Those crypto assets were in fact an investment contract within the meaning of the Supreme Court’s ruling, according to the agency.
The Court agreed. In a Memorandum granting the Commission’s request for summary judgment the Court found that “what the evidence in the record discloses is that LBRY promoted LBC as an investment that would grow in value over time through the company’s development of the LBRY Network. . .” — an investment contract. Remedies will be considered at a later date. See Lit. Rel. No. 25573 (November 7, 2022).
Conflicts/undisclosed fees: SEC v. McDermott, Civil Action No. 5:19-cv-04229 (E.D. Pa.) is a previously filed action in which the Court entered final judgment following a jury verdict in favor of the Commission. Defendants in the action are: McDermott Investment Advisors, LLC, a registered investment adviser; Dean Patrick McDermott, the firm’s owner; and McDermott Investment Services, an affiliated broker-dealer and Relief Defendant. The complaint alleged that Defendants sold Unit Investment Trusts to clients that charged a fee paid to the advisor. At the time of the transactions the identical securities were available without the fee, a fact not disclosed to the clients. The Court entered judgment against the Defendants by imposing permanent injunctions based on Advisers Act Sections 206(1) and 206(2). In addition, the judgement requires the payment of: McDermott MIA and MIS, jointly and severally, a penalty in the amount of $143,379.33; 2) McDermott, MIA and MIS, jointly and severally, $50,9983/60 in prejudgment interest; 3) MIA $110,000 in penalties; and 4) McDermott $50,000 in penalties. See Lit. Rel. No. 25570 (November 3, 2022).
SEC Enforcement – Filed and settled actions
Last week the Commission filed 3 civil injunctive actions and 2 administrative proceedings, exclusive of 12j, default, conflicts (which are included in the tabulation of cases), tag-a-long and other similar proceedings.
Insider trading: SEC v. Wong, Civil Action No. 1:22-cv-9618 (S.D.N.Y. Filed November 10, 2022) is an action which names as defendant Brian Wong. The action centers on the February 25, 2021 tender offer by Merck & Co. for shares of Pandion Therapeutics, Inc. Previously, the Commission filed a complaint against Seth Markin and his close friend and Brian Wong’s brother, Brandon Wong. It alleged that prior to the deal announcement Mr. Markin misappropriated inside information about the deal from his romantic partner, an associate at a large law firm working on the deal. Mr. Markin used the information to trade and tipped Brandon Wong who also traded. Brandon Wong also furnished the information to his brother Brian Wong who also traded. Brian Won has trading profits of over $400,000 following the deal announcement. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is pending. Brian Wong consented to the entry of injunctive relief with monetary remedies to be determined at a later date on motion from the Commission. See Lit. Rel. No. 25576 (November 10, 2022).
Misappropriation: SEC v. Clason, Civil Action No. 3:20-cv-01279 (D. Conn.) is a previously filed action which named as defendant Matthew O. Clason, an employee of an investment adviser. The complaint alleged that Mr. Clason, an employee of the advisory, misappropriated millions of dollars from an advisory client. In resolving the action Defendant consented to the entry of a final judgment, entered by the Court, which imposed a permanent injunction based on Advisors Act Sections 206(1) and (2). The judgment also directs the payment of $634,472 in disgorgement and prejudgment interest. That amount is deemed satisfied by the restitution ordered in the parallel criminal case. There Defendant pleaded guilty and was sentenced to serve 30 months in prison in the parallel criminal case. Defendants was directed to serve 30 months in prison. See Lit. Rel. No 25574 (November 9, 2022).
Unregistered securities: In the Matter of PIC Remegade Properties, LLC, Adm. Proc. File No. 3-1238 (November 9, 2022) is an action against the company. The firm sought to sell securities under Rule 506(c) which provides for an exemption from registration. PIC, however, failed to assess if certain investors were accredited. Thus, the exemption was not available. The Order alleges violations of Securities Act Sections 5(a) and 5(c). To resolve the proceedings, Respondent consented to the entry of a cease-and-desist order based on the Sections cited in the Order. The firm will also pay a penalty of $400,000.
Mismarking NAV: SEC v. Infinity Q Diversified Alpha Fund, Civil Action No. 1:22-cv-09608 (S.D.N.Y. Filed November 10, 2022) is an action which names a defendant, a pooled investment vehicle. Over a four-year period, beginning in 2017, James Velissaris, CIO of the Fund, intentionally mismarked the NAV. The complaint alleges violations of Rule 22c-1. The Fund agreed to settle and filed an application for an order under Section 22(e)(3) to suspend redemptions. The request was approved. Under the settlement a Special Master will be appointed to oversee the resolution of the financial issues. The Fund also consented to the entry of a permanent injunction based on Rule 22c-1. See Lit. Rel. No. 25575 (November 10, 2022).
Insider trading: SEC v. Rayapureddy, Civil Action No. 22 Civ. 1592 (W.D. Pa. Filed November 10, 2022) is an insider trading action which names as defendant Ramkumar Rayapureddy, formerly the Global Chief Information Officer of Mylan N.V., a large pharmaceutical company. Between 2017 and 2019 Defendant furnished inside information to Dayakar Mallu, a friend who also worked at Mylan for a period. Specifically, the information concerned the financial results of the firm, an acquisition and at least one FDA application. In each instance Mr. Mallu traded profitably and paid a portion of the proceeds to Defendant. Overall, the trading profits were $7,264,008 while the losses avoided totaled $703,337. The complaint alleges violations of Exchange Act Section 10(b). The case is pending. The Department of Justice Fraud Section filed a parallel criminal action.
Insider trading: In the Matter of Michael E. Mueller, Adm. Proc. File No. 3-21234 (November 4, 2022). This action centers on the acquisition of Layne Christensen Company by Granite Construction Inc., announced in February 14, 2018 prior to the market open. By October 2017 broker John Mendes’ close friend, Granite employee Andre Dabbaghian had told his friend that his employer was interested in acquiring Layne. Respondent Mueller subsequently authorized his broker, John Mendes, to purchase Layne shares for him. Mr. Mueller also recommended that a close friend purchase the shares. Friend in fact did buy the shares. Following the deal announcement the share price increased 18%. Mr. Mueller had trading profits of over $38,000. The complaint alleges violations of Exchange Act Section 10(b). To resolve the proceedings Respondent consented to the entry of a cease-and-desist order based on the Section cited in the Order. Respondent also agreed to pay disgorgement of $38,075.32, prejudgment interest of $d8,003.38 and a penalty of $52,318.87
EXAMS
Rule 606 Disclosures: EXAMS – the Division of Examinations – published a Risk Alert on November 10, 2022, providing its Observations Related to Regulation NMS Rule 606 Disclosures (here). That Rule requires broker-dealers to provide enhanced disclosures about the handling of customer orders. Specifically, it was designed to provide better insight into factors that may influence routing decisions. The observations of the Division are divided into three segments in the Alert: 1) Issues with quantifiable disclosures; 2) issues with material aspect disclosures; and 3) supervision. Overall, the Alert provides a guide to meeting the enhanced disclosure requirements of the Rule as well as ensuring that the firm meets its compliance obligations. In essence, the Alert gives broker-dealers a clear guide for installing the new disclosure requirements and ensuring that its compliance systems and procedures are properly implemented.
ESMA
Plan: The European Securities and Market Authority announced its strategic priorities for the next five years. The regulator also announced its long-term priorities and how it plans to respond to future challenges and developments in a release dated October 10, 2022 (here).
Hong Kong
Joint operation: The Securities and Futures Commission of Hong Kong announced a joint operation with the Independent Commission Against Corruption to focus on a sophisticated ramp-and-dump syndicate. The regulator announced that the group had profits of about $191 million. Members of the syndicate have been arrested (here).
Singapore
Collaboration: The New York Fed and the Monetary Authority of Singapore will collaborate to explore potential enhancements to cross-border payments using wholesale CBDCs, in a release dated November 11, 2022.
U.K.
Advisory group: The Financial Conduct Authority announced that it is seeking members for a new, innovation Advisory Group. The role of the group is to share views regarding FinTech and RegTech, act as a critical friend to the innovation department and pass important messages to the members and networks (here).