Securities Industry Commentator by Bill Singer Esq

October 31, 2018
In an Indictment filed in the United States District Court for the Southern District of California, alleged Chinese intelligence officers Zha Rong and Chai Meng and other co-conspirators worked for the Jiangsu Province Ministry of State Securitiey ("JSSD"), which is a provincial foreign intelligence arm of the People's Republic of China's Ministry of State Security ("MSS"). The Indictment alleges that from at least January 2010 to May 2015, JSSD intelligence officers and their team of hackers, including  Zhang Zhang-Gui, Liu Chunliang, Gao Hong Kun, Zhuang Xiaowei, and Ma Zhiqi, focused on the theft of technology underlying a turbofan engine used in U.S. and European commercial airliners.  Members of the conspiracy, allegedly assisted and enabled by JSSD-recruited insiders Gu Gen and Tian Xi, hacked the French aerospace manufacturer and also conducted intrusions into other manufacturers. Defendant Zhang Zhang-Gui is also charged, along with Chinese national Li Xiao, in a separate hacking conspiracy, which asserts that Zhang Zhang-Gui and Li Xiao leveraged the JSSD-directed conspiracy's intrusions, including the hack of a San Diego-based technology company, for their own criminal ends.
Over a period of at least 7 years, Arthur Lamar Adams used his wholly-owned Madison Timber Properties, LLC, as part of a Ponzi scheme to defraud over 250 investors in 14 states by soliciting millions of dollars of funds under false pretenses, failing to use the investors' funds as promised, and converting investors' funds to Adams's own benefit without the knowledge of the investors. Instead of investing his clients' money, Adams used the invested funds for his own personal benefit and for purposes other than those represented to investors, which also included making payments due and owing to other investors. Adams secured loans by falsely representing to investors that Madison Timber Properties was in the business of buying timber rights from landowners and then selling the rights to lumber mills at a higher price; however, in only a few instances did Adams or Madison Timber Properties have such timber rights or mill contracts. Adams pled guilty in the United States District Court for the Southern District of Mississippi to one count of wire fraud and was sentenced to 235 months in federal prison plus three years of supervised release and ordered to pay full restitution. 

SEC Stops Broker's Ongoing Theft of Retirees' Investment Funds and Obtains Asset Freeze (SEC Litigation Release No. 24328)
In a Complaint filed in the United States District Court for the Northern District of Georgia, the SEC charges Sean Kelly with violating the antifraud provisions of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and (2) of the Investment Advisers of 1940. Further, the Complaint charges Kelly's companies,  Lion's Share Financial of East Cobb, Inc., Lion's Share & Associates, Inc., and Lionsshare Tax Services, LLC,  with violating certain of those same statutes, or aiding and abetting certain of Kelly's (or his other companies') underlying violations. The Complaint alleges that Kelly used his companies to raise at least $1 million from 12 investors, including elderly retirees, promising that he would invest their funds in a variety of investment products including private placements and real estate funds. Allegedly, Kelly spent funds on personal expenses including Super Bowl tickets, luxury vacations, and cash withdrawals; and, after having received an SEC subpoena, he did not show up for his scheduled testimony after informing the SEC's staff that he would show up and "come clean." The Court granted the SEC's request for an asset freeze, temporary restraining order, and an accounting. In a parallel action, on the same day, the U.S. Attorney's Office for the Northern District of Georgia filed criminal charges against Kelly and arrested him. READ the FULL TEXT: Complaint
In today's Blog we literally got it all. We have a fraudulent real estate company that apparently crashed and burned. We got a brother touting that company as an investment to his sister, a financial advisor, who, in turn, apparently touted it to her customers and her father, who lost a bundle. We got a criminal prosecution. We got a FINRA arbitration. We start off with a lawsuit in state court but wind up in federal court, and from there in federal appeals court. We got all sorts of allegations and defenses about prosecutorial misconduct and failure to supervise and statutes of limitations. It's exhausting to read through it all. It was equally exhausting to research the facts and write it up. I would suggest you get a strong, black cup of coffee before you start reading. While you're up, maybe get a donut -- why not?
Former Valeant Pharmaceuticals International, Inc. executive Gary Tanner and former Philidor Rx Services LLC Chief Executive Officer Andrew Davenport were found guilty by a jury in the United States District Court for the Southern District of New York of conspiracy to commit honest services wire fraud, honest services wire fraud, conspiracy to violate the Travel Act, and conspiracy to commit money laundering.  Both Defendants were sentenced to one year and one day in prison plus two years of supervised release and ordered to each to forfeit approximately $9.7 million. As set forth in part in the DOJ Release:

Valeant and Philidor began negotiations for Valeant to purchase Philidor, and Valeant ultimately purchased an option to buy Philidor (the "Option") in exchange for $133 million in payments to Philidor's owners, and the promise of $100 million in additional milestone payments if Philidor were to meet certain sales targets.  Despite the duty of loyalty owed by TANNER to Valeant, during negotiations relating to the Option, TANNER and DAVENPORT secretly made preparations for TANNER to receive a multimillion-dollar kickback out of the money that Valeant was going to pay Philidor's owners for the Option.  Among other things, TANNER and DAVENPORT set up shell company bank accounts in order to launder the kickbacks to TANNER.  While these preparations were underway, TANNER secretly advised DAVENPORT on his negotiations with Valeant.  TANNER did this in contravention of his duties to Valeant and despite the fact that he was also internally advising Valeant in its negotiations with DAVENPORT about the Option.   

In addition to secretly helping DAVENPORT negotiate against Valeant in exchange for the promise of a kickback from DAVENPORT, TANNER took other actions to benefit Philidor and DAVENPORT personally, and against the direction of his supervisors at Valeant.  For example, TANNER's supervisors directed him to identify other pharmacies that Valeant could use to distribute its drugs, in order to minimize the risks of overreliance on Philidor.  TANNER deceived his supervisors into believing that he was pursuing their direction in good faith when, in fact, he lied about participating in meetings and doing due diligence on potential competitors to Philidor.  In addition, TANNER helped Philidor and DAVENPORT secure favorable payment terms.

In order to keep their scheme hidden from Valeant, TANNER often used a Philidor email account that TANNER maintained in the name of "Brian Wilson" to communicate with DAVENPORT.  TANNER also pretended to be Brian Wilson in at least one meeting that he and DAVENPORT participated in on behalf of Philidor. 

In December 2014, Valeant acquired the Option.  DAVENPORT, through two different entities that he controlled, received approximately $50 million of the $133 million that Valeant paid.  DAVENPORT transferred $9.7 million of that amount to TANNER through a shell company he controlled, and then to a shell company controlled by TANNER, an entity called Befrielse Consolidated, LLC ("Befrielse").  TANNER concealed his receipt of this money from Valeant, in violation of his fiduciary duties to Valeant, and in violation of Valeant's conflict of interest policies.  Prior to receiving the funds, TANNER had repeatedly certified to Valeant that he was in full compliance with Valeant's Standards of Business Conduct, which prohibited any conflicts of interest without full disclosure and approval by company management. 

After the Option purchase was completed, TANNER continued to use his position at Valeant to advance the interests of Philidor and DAVENPORT, including by resisting Valeant's efforts to collect payments from Philidor owed to Valeant and pursuing milestone payments under the terms of the Option that he secretly expected to share in.  In communications concerning the scheme, using TANNER's secret Brian Wilson email account, DAVENPORT discussed with TANNER how TANNER would secretly continue to promote DAVENPORT's interests, even while he purported to represent Valeant's interests as the Valeant executive responsible for Philidor.  Among other things, DAVENPORT stated that he pictured his and TANNER's "butch and sundance ride into the sunset (or off the cliff as in the flick)," to which TANNER responded, using the secret Brian Wilson account: "[G]ave me a good chuckle when I just saw it. Will have to keep playing the game :)."  .   

In the Matter of the Application of Thaddeus J. North For Review of Disciplinary Action Taken by FINRA (SEC Opinion. '34 Act Rel. No. 84500; Admin. Proc. File No. 3-17909)
Thaddeus J. North, formerly associated with FINRA member firm Southridge Investment Group LLC sought the SEC's review of FINRA disciplinary action finding that he had violated FINRA, NASD, and MSRB rules by failing to establish a reasonable supervisory system for the review of electronic correspondence, failing to reasonably review electronic correspondence, and failing to report a relationship with a statutorily disqualified person. FINRA imposed a two-month suspension in all principal and supervisory capacities and a 30-day suspension in all principal and supervisory capacities to run consecutively; fined North $40,000; and ordered North to pay hearing and appeal costs. The SEC sustained FINRA's findings of violations and imposition of sanctions. The SEC Opinion includes on pages 12 - 13 this intriguing analysis and commentary (Ed; footnotes omitted0]:

[I]n general, good faith judgments of CCOs made after reasonable inquiry and analysis should not be second guessed. In addition, indicia of good faith or lack of good faith are important factors in assessing reasonableness, fairness and equity in the application of CCO liability. 

While matters involving the determination of CCO liability are facts and circumstances specific, there are matter types where determinations of individual liability generally are straightforward. For example, absent unusual mitigating circumstances, when a CCO engages in wrongdoing, attempts to cover up wrongdoing, crosses a clearly established line, or fails meaningfully to implement compliance programs, policies, and procedures for which he or she has direct responsibility, we would expect liability to attach. In contrast, disciplinary action against individuals generally should not be based on an isolated circumstance where a CCO, using good faith judgment makes a decision, after reasonable inquiry, that with hindsight, proves to be problematic. When the facts and circumstances of matters fall outside these relatively clear examples of where liability should or should not attach, liability determinations will require matter-specific analysis and informed judgment. 

With that perspective, in this instance, on the record before us, it is clear that North failed to make reasonable efforts to fulfill the responsibilities of his position. It is the evidence of North's actions and failures to act that is the basis for his liability. North's failure to fulfill his own responsibilities was egregious. Here, North ignored red flags and repeatedly failed to perform compliance functions for which he was directly responsible. Under these facts and circumstances, FINRA's disciplinary action was clearly appropriate. 

In reaching this conclusion, we recognize that North was not the only person at Southridge whose performance may have been deficient with respect to the written supervisory procedures and review of electronic communications. The Commission has held repeatedly that the "chief executive officer of a brokerage firm is responsible for compliance with all of the requirements imposed on his firm ‘unless and until he reasonably delegates particular functions to another person in the firm and neither knows nor has reason to know' that a problem has arisen." Although Schloth may have delegated the compliance functions with respect to  establishing and maintaining adequate written procedures and reviewing electronic correspondence to North, that did not end his responsibilities. "It is not sufficient for the person with overarching supervisory responsibilities to delegate supervisory responsibility to a subordinate, even a capable one, and then simply wash his hands of the matter until a problem is brought to his attention. . . . Implicit is the additional duty to follow-up and review that delegated authority to ensure that it is being properly exercised." The record does not indicate what actions Schloth took to monitor whether North was reviewing electronic communications, and we are troubled by the possibility that North could have abdicated his own responsibilities to review those communications without Schloth knowing. 

Finally, it is not clear from the record why FINRA did not charge Southridge, although we take official notice of the fact that Southridge terminated or withdrew its registration over a year prior to FINRA instituting its action here. "A firm . . . can act only through its agents, and is accountable for the actions of its responsible officers." We think it important to make it clear to firms-by holding them responsible when there are problems-that it is in their interest to have effective, diligent compliance officers to help them remain in compliance with their obligations. Further, as we have said previously, "broker-dealers must provide effective staffing, sufficient resources and a system of follow-up and review to determine that any responsibility to supervise delegated to compliance officers, branch managers and other personnel is being diligently exercised." Indeed, in some cases it may be more appropriate to hold the firm liable rather than the compliance officer. In this case, we agree with FINRA that its disciplinary action against North was warranted.
James Farinella pled guilty to a criminal Information in the United States District Court for the District of New Jersey to one count of conspiracy to commit securities fraud in connection with  a $1.1 million scheme that artificially inflated the stock price of Pazoo Inc, which was essentially a shell that Farinella controlled 98 percent of  its free-trading shares. The SEC has a civil complaint pending against Farinella. READ the FULL TEXT Infornmation

SEC Obtains Preliminary Injunction in International Microcap Fraud Scheme (SEC Litigation Release No. 24327)
In a Complaint filed in the United States District Court for the District of Massachusetts, the SEC charged Roger Knox and his company Wintercap SA with helping microcap securities holders evade federal securities laws that restrict sales by large shareholders by concealing ownership and providing anonymous access to brokerage account through which shares could be sold in the United States. Allegedly, Michael T. Gastauer aided and abetted the fraud by establishing several U.S. corporations and allowing Knox to use their bank accounts to disburse the proceeds of his illegal stock sales.  Allegedly, the scheme generated over $165 million of illegal sales of stock in at least 50 microcap companies. Also, the Complaint names as relief defendants two family members of Gastauer and a U.K. entity Gastauer controlled. The SEC obtained a preliminary injunction and continued asset freeze against Knox, Gastauer, and their entities. In a parallel criminal action,  a federal grand jury indicted Knox on one count of securities fraud and one count of conspiracy to commit securities fraud.
The former owner and manager of Enable Invest Ltd., Irfan Amanat, was found guilty by a jury in the United States District Court for the Southern District of New York on one count each of conspiracy to commit wire fraud; wire fraud;aiding and abetting investment advisor fraud;, and conspiracy to commit securities fraud, make false statements in annual and quarterly SEC reports, and make false statements to auditors. In December 2017 , co-defendants Omar Amanat and Kaleil Isaza Tuzman were convicted.As set forth in the DOJ Release:

The first scheme involved a fraud on investors in Maiden Capital LLC ("Maiden Capital"), a hedge fund based in Charlotte, North Carolina.  Stephen Maiden was the managing member of Maiden Capital.  Between in or about March 2009 and in or about June 2012, AMANAT, along with Maiden and others, devised and carried out a scheme to hide the fact that investments by Maiden Capital in Enable, an investment vehicle owned and managed by AMANAT, had been lost.  To facilitate the scheme, Maiden, with AMANAT's assistance, generated fictitious client account statements that failed to disclose millions of dollars in Enable-related losses. 

The second scheme involved accounting fraud at KIT digital ("KITD"), a publicly traded company based in New York, New York, and Prague, Czech Republic.  From at least in or about 2009 through in or about 2012, AMANAT, along with Tuzman, KITD's former CEO, and Robin Smyth, KITD's former CFO, engaged in an illegal scheme to deceive KITD shareholders, members of the investing public, KITD's independent auditors, and others concerning KITD's true operating performance and financial results.  Instead of informing KITD's auditors and investors that millions of dollars that KITD had invested with Enable had been lost or fraudulently misappropriated, AMANAT falsely represented that KITD's investment with Enable was sound and earning steady interest.