Disgorgement and Penalties Upheld – Will Be Inevitable Where There Is Egregious Fraud Regardless Of Inability To Pay

Maria T. Giesige, Exchange Act Rel. 60000, May 29, 2009


Time since appeal filed – 6 months 30 days
Time since last brief filed – 4 months 24 days
Pages – 13
Footnotes – 27

This is an important decision. Although the Commission could have imposed the monetary sanctions because the evidence was not introduced at trial it ruled that due to the egregious nature of the fraud penalties and disgorgement would have been imposed in any event.

The Commission ruled that disgorgement is appropriate, regardless of respondent's inability to pay because she "received this money as compensation for the very transactions that constituted the violations . . . ." It also upheld third tier penalties of $500,000 noting that inability to pay is "but one factor" to be considered. "Where the egregiousness of [the] conduct outweighs any consideration of . . . inability to pay . . . the public interest requires that the civil penalty be imposed."

This appears to be a significant tightening of the Commission's position. This case means that inability to pay will not automatically result in the Commission deciding not to impose disgorgement or penalties and that when there is significant fraud disgorgement and penalties are all but inevitable.

Giesige was associated with a broker-dealer and later registered as an investment adviser. The ALJ found that she made material misstatements and omitted material facts in selling securities of Carolina Development Co., sold unregistered securities, and also acted as an unregistered broker-dealer because because she sold away by not notifying her employer of her sales. The ALJ entered a cease and desist order, barred from association with a broker, dealer, or investment adviser, ordered disgorgement of $21,000 and ordered her to pay a $500,000 penalty.

The Commission upheld the ALJ's findings and sanctions. Giesige did not challenge the findings of violations on appeal. Nor did she challenge the cease and desist order or the bars. She asked that the disgorgement and penalty amounts be removed due to her inability to pay.

Discussion

Giesige was a rep from 1986 until 2007. In 2005 and 2006 on her recommendation fifty of her clients bought $1.49 million of Carolina Development securities. Giesige and her husband personally invested $29,000 in Carolina. Carolina purported to be in the real estate development business and touted the prospect of an impending public offering of its stock. It never registered its securities with the SEC and it took no steps to consummate an IPO. Its securities traded on the OTC bulletin board. In late 2005 the Commission sued Carolina and obtained a preliminary injunction and the appointment of a receiver. The receiver found that Carolina had no business revenues. Its only source of money was new investors from whom it had raised $52 million. Its only assets were real estate and it had no financial books and records. The receiver liquidated the company for $8 million.

Giesige gave offering materials to customers that she admitted she did not understand. She made no effort to verify any of the information. Although the company claimed its financial statements were audited she never obtained a copy of the audited financials. Some of her customers testified that in recommending Carolina securities she gave the impression she had done substantial due diligence. Giesige received $21,000 in commissions and 13,900 shares of Carolina stock in sales commissions. She also claimed that an IPO at $9 per share was imminent despite knowing that the stock was quoted in the pink sheets for $.30 per share. She also made price projections – claiming that the price of the stock would rise from $3 to $9 per share in a few months. Most of her customers were unsophisticated and had limited income and savings. Many borrowed against their IRAs to fund their investments. She did not notify her broker-dealer employer of her sales of Carolina stock.

Despite being represented by counsel Giesige offered no evidence at the trial of her inability to pay disgorgement or penalties. She tried to introduce evidence of her financial condition in her post-trial brief. The ALJ refused to allow this evidence as untimely. The Commission specifically upheld this ruling by the ALJ based on Commission Rule 340(b) that requires post-trial submissions to cite to evidence in the trial record. Inability to pay must be introduced at trial in order to allow the Division of Enforcement to contest it.

Finally, the Commission found that Giesige's conduct was so egregious that it would not waive disgorgement or penalties in any event. It found her fraud knowing or extremely reckless.

Comment

The Commission announces that it will not waive disgorgement or penalties based on inability to pay where the fraudulent conduct was knowing or extremely reckless. Practitioners should also note that the Commission will not consider inability to pay evidence that is not introduced at trial. Attempting to introduce such evidence in post–trial briefs will not be countenanced.

NYSE Sanctions Against Firm For Submitting Inaccurate Trading Data Upheld

Schone-Ex, LLC, Exchange Act Rel. 57857 (May 23, 2008)

Time since appeal filed - 10 months, 7 days

Times since last brief - 7 months, 5 days

Pages - 15

Footnotes - 33

Summary

This case is interesting because the Commission adopted a "destruction of the business" test for evaluating whether fines are excessive or oppressive (the statutory test) with virtually no discussion and citation to only one case which does not rule that to be the exclusive definition of the statutory terms. 

NYSE requested that Shone-Ex (a member firm) submit data to it concerning short sale transactions through a so-called "blue sheet."  The firm made an inaccurate response and was also sanctioned for failing to supervise its blue-sheet supervisory procedures.  Blue sheets are a mechanism whereby the SEC, and other regulators request that firms supply trading data on selected trades, usually as part of a regulatory investigation.  These requests and responses are now done electronically but in the distant past (for example when I first went to work for the SEC) they were done by a paper form on blue paper sent to the firm by the regulators (and hence the name "blue sheet").  Regulators traditionally use these forms to determine the names and account numbers of traders.

NYSE censured the firm and fined it $300,000.  The Commission upheld the sanctions.

NYSE's blue sheet requests were in 2002 and 2004.  Shon-Ex executes trades for an affiliated clearing firm, Schonfeld Securities.  Both firms have the same CEO and compliance officer.  Schone-Ex contracted with an independent data processing firm to file blue sheets with regulators.  During the period in question, no one at the firm verified the accuracy of submissions made by the data processing firm even though copies were sent to the firm.  In June  2004 NYSE discovered that blue sheet responses concerning 146 trades wrongly showed 100 short trades as long.  Schone-Ex's CEO contacted the data firm, but it was slow to correct the reporting errors.  In November 2004 the firm notified NYSE that it had submitted inaccurate blue sheet responses from June through October.  Thus, the exchange did not obtain accurate data until November.  The firm did not put into place procedures to ensure the accuracy of blue sheet responses until May 2005.

At trial, even Schon-Ex's expert agreed that the blue sheet system is a vital regulatory surveillance system.  

Schone-Ex admitted that it submitted erroneous data to NYSE and did not maintain adequate procedures to verify the accuracy of data submitted on its behalf by the data processing firm. It noted that the trades were accurately recorded on its own books and that the errors were solely those of the data processing firm.

The primary challenge on appeal was Schone-Ex's claim that the penalty was excessive.  Exchange Act Section 19(e) requires that the SEC sustain NYSE sanctions unless it finds that the sanction is excessive, oppressive or imposes an unnecessary or inappropriate burden on competition.  In evaluating sanctions the SEC addresses "the nature of the violation and the mitigating factors."  The SEC also evaluates the seriousness of the offense, the harm to the investing public, the potential gain to the broker, the potential for repetition, and the deterrent value on the offending broker and others.  Further, the courts have directed that the SEC determine that sanctions are "remedial and not excessive or oppressive."

The Commission found that the record was unclear as to whether the NYSE investigation was hindered by the inaccurate submissions (indeed NYSE found that the harm to the investigation "should not weigh heavily" in assessing a penalty).  It nevertheless concluded that the misconduct was "significant."  In doing so the Commission noted the critical regulatory role of blue sheet responses.  It further noted that the inaccurate data submitted covered trades over a several year period.  The Commission found that Schone-Ex did not promptly and forcefully move to correct the problems or to put surveillance procedures into place.  

Schone-Ex also complained that in supporting the sanctions, NYSE relied on sanctions in settled disciplinary actions against other firms.  The Commission noted that NYSE rules specifically allow reference to prior disciplinary actions without exempting settlements.  

Practitioners should note that the SEC also relies on settled SEC matters as precedent for substantive law.  See, Carl L. Shipley, Release 34-10870, fn. 6 (June 21, 1974), 1974 SEC LEXIS 3113 ("A long series of such non-adjudicative orders issued in many cases may be significant for certain purposes as pointing to a settled administrative construction or practice. But an isolated order or two of [that type] is of no general import. Such cases are not to be confused with those in which we accept an offer of settlement, issue an order that makes findings, and imposes the sanction assented to by the settling respondent or respondents, and either together with the order or at a later time issue an opinion stating our views on the issues raised."). The Supreme Court has long recognized that "the interpretation of an agency charged with the administration of a statute is entitled to substantial deference."  Blum v. Bacon, 457 U.S. 132, 141 (1982).  

Another significant factor considered by the Commission was that Schone-Ex had three prior disciplinary actions, including one involving failure to supervise.  The Commission noted that NYSE had also considered the disciplinary history of a subsidiary of the firm, but noted that it did not consider that matter.

Last, the Commission rejected Schone-Ex's claim that the fine was excessive.  It noted that the firm had not established that the fine "threatens its business."  Needless to say, this is a very high bar for a firm challenging a sanction to meet.

Comment

This case indicates that the Commission takes the failure of firms to submit accurate trading data to regulators very seriously.  It will reverse a fine as excessive only if the firm can show that the penalty is so large as to "threaten [the] business" of the firm.  Needless to say, this construction of the statutory words "excessive or oppressive" are ready made for appeal.  The Commission justified its conclusion only by quoting from McCarthy v. SEC, 406 F.3d 179, 190 (2d Cir. 2005) ("a compelling argument can be made that suspending McCarthy now will not serve remedial interests and will work an excessive and punitive result - namely, the destruction of the brokerage practice McCarthy has built during several years of rule-abiding trading.").  The fact that in McCarthy the Court found destruction of the business to be "excessive or oppressive" of course does not mean that only destruction of the business can be deemed "excessive or oppressive."  Its willingness to adopt the destruction of the business test with no further discussion and analysis seems to run a significant risk of appellate reversal.  So, once again we see an ipse dixit pronouncement from the Commission, this time in connection with a significant regulatory standard, namely when industry fines will be upheld.

Phlo Corp., et. al., Exchange Act Rel. 55562 (March 30, 2007)

Transfer agent, Issuer reporting violations

Time between appeal and decision – 12 months, 16 days
Time between last brief and decision – 9 months, 25 days
Pages – 28

Comment

Perhaps the most significant ruling in this case is the imposition of a cease and desist order against the company whose transfer agent registration was revoked and officer who was barred from transfer agent association because the cease and desist orders would serve the remedial purpose of encouraging [them] "to take their responsibilities more seriously in their future dealings with the clearance and transfer systems and the Commission." In justifying this sanction the Commission stated, "[w]e find that the record as a whole, especially the evidence with regard to the seriousness, recentness, and recurrent nature of the violations, the harm to the marketplace and the regulatory scheme, and the very high degree of scienter, establishes a sufficient risk that Respondents would commit future violations to warrant imposition of cease-and-desist orders. Based on all of these factors, we find cease-and-desist orders against Respondents to be in the public interest."

Also significant is the fact that the Commission increased the penalty against one respondent from $50,000 to $100,000. That respondent was responsible for the transfer agent violations and failed to cooperate with an SEC staff examination.

Finally, the Commission overturned the ALJ's sanction of revoking the issuer's registration because despite the egregious past violations, the company has devoted "significant resources to satisfying its reporting obligations," has become current with its periodic filings, and retained a consultant to improve its internal accounting functions. It did impose a cease and desist order against future filing violations. It is therefore clear that the Commission is reluctant to revoke the registration of a delinquent issuer that has become current and has taken other steps to make repeat violations less likely and will in the future be subject to a cease and desist order.

Key points

• The Commission considered as evidence a statement in a responpondent's Wells submission that she contradicted in her oral trial testimony.
• "'The prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership . . . , are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors.' Failure to comply jeopardizes the efficacy of the Congressionally-mandated national system for the prompt and accurate clearance and settlement of transactions in securities." (footnotes omitted).
  A transfer agent is required to keep records demonstrating that it has complied with the turn-around rule.
• "A willful violation of the securities laws means merely 'that the person charged with the duty knows what he is doing.' Wonsover v. SEC, 205 F.3d 408, 414 (2000) (quoting Hughes v. SEC, 174 F.2d 969, 977 (D.C. Cir. 1949)). There is no requirement that the actor 'also be aware that he is violating one of the Rules or Acts.' Id. (quoting Gearhart & Otis, Inc. v. SEC, 348 F.2d 798, 803 (D.C. Cir. 1965))
• The aiding and abetting scienter requirement can be satisfied with proof of actual knowledge or reckless disregard.
• Incomplete response by transfer agent to staff request for documents and to conduct physical examination for 2 ½ months violates the obligation to make required records available for inspection by the SEC staff.
• The person who delayed the transfer agent's response and submitted an incomplete response to the staff document request was an aider and abetter of the violations and a cause.
• There is no scienter requirement to establish a violation of the periodic reporting requirements of Exchange Act Section 13.
• Corporate officer who "engaged in acts and omissions that he knew or should have known would result in [the company's] reporting violations was a cause of those violations.
• The fact that the ALJ denied respondents request for a postponement of the hearing did not establish that the ALJ was biased against respondents and should have withdrawn from the proceeding.
• Revocation of transfer agent registration was appropriate as the failure to transfer items occurred for a three month period that the Commission characterized as egregious, recurrent, and prolonged.
• The fact that the company no longer acts as a transfer agent is irrelevant in considering sanctions as there is an opportunity for future violations because it could in the future resume that role.
• Despite revocation of the transfer agent's registration and a bar from association with a transfer agent for an individual, a cease and desist order was in the public interest in order to "serve the remedial purpose of encouraging [them] to take their responsibilities more seriously in their future dealings with the clearance and transfer systems and the Commission."
• A $25,000 penalty was imposed for each month respondent aided and abetted transfer agent violations and another $25,000 for failure to comply with staff inspection requests.
• Because the company only had revenues of $1,544 and was in financial difficulty, and had a going concern qualification of its financial statements, the penalty of $100,000 against the company imposed by the ALJ was overturned as not in the public interest.
• Because the proceedings against one respondent were instituted only under Sections 12(j) and 21C of the Exchange Act, no penalty was appropriate and the penalty imposed by the ALJ against that respondent was also overturned.

Summary

Phlo Corp. manufactured beverages and acted as its own transfer agent (and was so registered with the Commission) for its publicly traded securities. James Hovis was executive vice presidenet of the company and Anne Hovis was the company's general counsel. The initial decision found that Phlo willfully violated transfer agent turnaround requirements and failed to make documents available for inspection by SEC staff. It also found that A. Hovis aided and abetted and caused the transfer violations and failure to provide records for examination. The ALJ also found that Phlo failed to timely file periodic reports with the SEC from March 2003 through November 2005 and that J. Hovis aided and abetted and caused those violations. The ALJ ordered civil penalties of $100,000 against Phlo, $25,000 against J. Hovis and $50,000 against A. Hovis, revoked Phlo's transfer agent registration, barred A. Hovis from associating with any transfer agent and imposed cease and desist orders on all respondents.

The initial decision was upheld in all respects, except that the penalty for A. Hovis was increased to $100,000 and no penalties were imposed against the company and J. Hovis.

Exchange Act rules require that registered transfer agents turn around 90 percent of routine items within three business days. Reports sent to Phlo by its Depository Trust Corp. showed that for three months in 2003 Phlo failed to meet the three day turnaround rule for fifty-four items. Phlo did not offer evidence that it had met the three day requirement and there was no evidence the items were non-routine. A. Hovis also was notified by DTC staff of the failure to turn around items. A. Hovis also explicitely refused to transfer items to Cede & Co.(DTC's nominee). She claimed that DTC had no legal right to insist that securities be registered in the name of Cede. The SEC staff told A. Hovis Phlo was required to transfer to Cede if instructed to do so by DTC despite her claim that this was facilitating naked short selling in Phlo stock. During a heated conversation with SEC staff A. Hovis refused to provide a legal basis for her position. When the hearing in this matter began in September 2005, a number of the transfers had still not been completed. Indeed, at the time of the oral argument on appeal, some of the transfers were still pending.

SEC staff pursuant to the Commission's inspection authority requrested various documents from Phlo in late October 2003. The documents were never provided and at one point the staff visited the registered location of the transfer agent, which was locked. Despite a request from the SEC staff, A. Hovis never contacted the staff to arrange a date for an inspection of that registered location. Finally, in mid-January 2004, A. Hovis provided some, but not all of the requested documents. The remaining documents have never been produced.

Because the Division of Enforcement met its initial burden of showing turn around violations by proof that all fifty-four items received by Phlo in June through August 2003 were still outstanding in early September 2003, the burden then shifted to Phlo to refute that evidence. Further, Phlo failed to respond to a request for documents that sought the required logs which document a transfer agent's compliance with the turn around rule.

A. Hovis aided and abetted the transfer agent violations and Phlo's failure to provide requested documents to the SEC staff. A. Hovis was a cause of the violations as well.

Between March 2003 and November 2005 Phlo failed to timely file three annual reports and eight quarterly reports with the SEC (the delinquencies ranged from three days to twenty months). Six of the eleven filings were more than a year late. During this time the company had four auditors.

J. Hovis admitted he was responsible for overall management of the company. He signed the company's annual and quarterly reports. He was found to be a cause of Phlo's reporting violations.

It was appropriate under the Steadman factors to revoke Philo's transfer agent registration and bar A. Hovis from associating with a transfer agent. It is appropriate to impose cease and desist orders against Phlo and A. Hovis for transfer agent violations despite the revocation and bar to "serve the remedial purpose of encouraging [them] to take their responsibilities more seriously in their future dealings with the clearance and transfer systems and the Commission."