Securities Fraud: But Was It Even A Security?

What is a security, anyway? The California Court of Appeal tackled that question recently in a case about a loan between friends.

A good starting point is that the law considers a security to be an investment contract, but there’s more to it than that. You may be familiar with common examples like publicly-traded stocks and bonds, but sometimes it’s a tougher call.

California law recognizes two tests to determine whether a deal or transaction is a security. One is the state’s risk-capital test, and the other is the federal Howey test (from a U.S. Supreme Court case). California courts may apply either one to your case, their goal being to protect the public from shady investment schemes.

The narrower risk-capital test asks whether you indiscriminately solicited passive investments from the public at large. A passive investment is one whose success depends mainly or exclusively on the efforts of people other than the investors.

The broader federal test simply asks whether you solicited people to invest passively.

In this case, the defendant had persuaded a guy he knew to invest in his land-development deal. The investment was a $280,000 promissory note that promised to pay out as follows:

  1. If the land were sold, the guy would share in the net profits from the sale.
  2. If the land were developed, he would receive one residential acre of his choosing.
  3. If neither event took place within one year, he could call the note and get interest on top of principal at a rate of ten percent.

But things didn’t exactly pan out, and some years later, the local district attorney’s office charged the defendant with securities fraud.

The trial court partly dismissed the case because it ruled that the promissory note wasn’t a security but a simple loan.

The government appealed that ruling, but the appeals court agreed. Even under the federal test, the note wasn’t a security because it was carefully negotiated between the parties, and it called for repayment whether the venture succeeded or not. The defendant had even personally guaranteed it.

So the case could’ve been a breach of contract, or it could’ve been a fraud.

But it wasn’t a securities fraud because the note wasn’t a security.

Much Ado About Little

The U.S. Supreme Court decided its big insider-trading case of the term on Tuesday, and it turns out you still can’t toss a friend or family member a tip to trade on. Who knew?

Here are the facts. The defendant’s brother-in-law was an investment banker who advised major healthcare companies on mergers and acquisitions. Over time, he shared inside information about these corporate deals with his biological brother, who shared them with the defendant. By the time of defendant’s trial, the brothers had both pleaded guilty, and they testified that defendant knew the tips came from insider trading.

Well, the jury convicted him, and on appeal, he relied on a recent case out of New York that we wrote about here.

Under that case, he argued, insider trading required proof that the insider benefited financially from the tipping. In his case, however, the insider (banker) had tipped off his brother freely as a gift. Therefore, none of it was insider trading.

The problem was that the New York case didn’t say that. While insider trading does require the insider to benefit personally from the tip, the law has long defined such personal benefit to include the benefit you get from making a gift of confidential information to a relative or friend. The New York case didn’t change that, though it did question who should count as a friend (or relative, for that matter) in a world full of loose connections.

Still, the New York case had caused a stir in the white-collar-defense world over whether the Supreme Court would use this case to reshape the law of insider trading.

But this case was different, and the Court did no such thing.

SEC Reports Enforcement Results for 2016

As we wind down the calendar year, the Securities and Exchange Commission has already reported its enforcement results for the fiscal year that ended September 30.

In case you missed it, here’s the press release. Naturally, there’s some self-patting on the back, but if the past predicts the future, the agency is looking to file cases. Its numbers have climbed steadily over the last dozen years, and it continues to ramp up its use of big-data analytics and the whistleblower program, which it launched in 2011.

Here are some highlights from 2016.

  • The agency filed a total of 868 cases, which was a new single-year high.
  • It filed a record number of cases involving investment companies or advisers and a record number under the Foreign Corrupt Practices Act.
  • It obtained over $4 billion in judgments and orders, which matched the haul from each of the last two years.
  • It awarded more money to whistleblowers ($57 million) than in all prior years combined.

CFTC Launches New Website for Whistleblowers

Another thing about the Commodity Futures Trading Commission: Last month, the agency unveiled the new website for its whistleblower program at www.whistleblower.gov. It looks pretty good, and it’s easy to navigate. It tells you what you need to know about the program, including how to submit a tip and how to apply for an award.

The CFTC’s whistleblower program was created by the Dodd-Frank Act of 2010, and it provides monetary awards to people who voluntarily report violations of the Commodity Exchange Act. If your tip translates into an enforcement action that results in more than $1 million in sanctions, you stand to receive 10-30 percent of the money collected. The pay out may even include money collected by other agencies that piggyback off your successful tip.

Here’s the CFTC’s press release.

Meanwhile, the agency has apparently caught flak for the way it’s been accounting for its office leases, though after a year-long audit by the Government Accountability Office, it seems like much ado about little.

You can read a couple stories about it here and here, but after reviewing the GAO’s report, it’s hard for me to see the point of the whole exercise unless it was to fuel congressional squabbles over the CFTC’s budget.

And for my money, an agency that we’ve called on to regulate the multi-trillion-dollar derivatives markets needs a lot more than $250 million per year to do its job.

Federal Court of Appeals Vacates Lenient White-Collar Sentence

The overriding directive of federal sentencing law is to impose a sentence that is sufficient but not greater than necessary to accomplish the goals of sentencing: that is, to reflect the seriousness of the offense, promote respect for the law, provide just punishment, deter crime, protect the public, and rehabilitate the defendant. 18 U.S.C. § 3553(a).

Usually, the trial judges who preside over criminal cases get the benefit of the doubt when it comes to what’s a reasonable sentence. After all, they’re the ones who can size up defendants and witnesses personally and weigh the evidence firsthand.

But last week, a federal court of appeals sent a case back for resentencing because it questioned the reasonableness of the trial court’s sentence. A jury had convicted the defendant of wire fraud, bank fraud, and conspiracy, and based on the $1.7 million loss, the federal sentencing guidelines called for a range of 57 to 71 months in prison. The prosecutor had asked for 30 months in prison, but instead, the judge sentenced the defendant to one day in prison, three years’ probation, and $1.7 million in restitution.

At first blush, a one-day sentence may seem unreasonable in the case of a $1.7 million fraud, but as usual, the devil’s in the details, and in this case, the details that follow come straight from the appellate court’s opinion.

The defendant was a 60-year-old accountant who got involved in a business venture to recycle tires. Auspiciously, he was referred to a guy whose Australian company could supply and install the necessary equipment, though inauspiciously, he didn’t know that the other guy had failed in nine prior tire-recycling ventures. The two men eventually formed a new company that was owned 81% by the defendant and 19% by another one of the other guy’s companies. Their new company then set out to build a tire-recycling plant, and to that end, it entered into a $2.3 million contract with the other guy’s supply company to provide the equipment and installation. To fund the $2.3 million, the defendant invested $300,000 of his own money, while the other guy invested $300,000 by agreeing to discount the price of his equipment by that much. Their joint company then obtained the $1.7 million balance through a small-business loan, and that’s where the alleged fraud took place.

To obtain the small-business loan, the defendant applied for a bank letter of credit in order to disburse the loan proceeds to the other guy’s bank in Australia, but in the application, he specified that if all of the equipment were not delivered in one shipment, the new company would not have to pay.

Sure enough, when the equipment arrived, it was missing the tire shredder, which was a vital piece, and the defendant was apparently so angry that he complained to Australian authorities as well as the FBI, the SEC, and the SBA’s Office of Inspector General. This prompted the FBI to open an investigation.

In the meantime, however, the other guy falsified a packing slip to show that the shredder would ship, and as a result, the bank honored the letter of credit and transferred $1.7 million to the guy’s bank.

When the money arrived, half of it immediately went to cover an overdraft of the supply company’s account, and the rest was appropriated by the other guy to pay other creditors. Poof! Just like that, the $1.7 million was gone, and the defendant lost his $300,000 investment in the failed venture.

Both men got indicted, but the government made a deal with the other guy, who testified against the defendant and got three years’ probation in return. The defendant went to trial and was convicted on four of ten counts. Among other things, the other guy testified that the defendant had told him to falsify the packing slip. Who knows. Perhaps that was part of the defendant’s master plan to lose $300,000.

At the defendant’s sentencing, the trial judge acknowledged that the defendant had “cut some corners in the heat of the moment,” but he also expressed his belief that the defendant did not go into the venture to rip someone off. By contrast, the judge was “offended to [his] very core” by the other guy’s conduct, whom he viewed as “by far the principal wrong-doer.”

Noting that the defendant, who had no criminal history, was now a convicted felon who would lose his accounting license, and noting further that the defendant had lost his own shirt in the ordeal and could not pay any restitution if he were sitting in prison, the judge imposed a sentence that he thought was sufficient but not greater than necessary to do the job.

But apparently, it wasn’t punishment enough for the court of appeals.

Bank Fraud. Even If You’re Not Trying to Defraud a Bank.

Two days before the Supreme Court’s watershed opinion on cell phones, it published another unanimous opinion on a more esoteric topic: bank fraud. Yeah, that’s right, bank fraud.

In Loughrin v. United States, the Court held that the federal bank-fraud statute can cover cases in which you intend to defraud someone or something other than a bank. How can that be?

The Court began with the text of the statute. It punishes anyone who knowingly executes or attempts to execute a scheme to do one of two things: (1) defraud a financial institution; or (2) obtain money or property owned by, or in the custody or control of, a financial institution “by means of false or fraudulent pretenses, representations, or promises.” 18 U.S.C. § 1344. The defendant was convicted under the second clause.

So what did the defendant do? First, he pretended to be a Mormon missionary going door to door in a residential neighborhood. When people weren’t looking, he’d raid their mailboxes and steal any checks he could find. Next, he’d alter the checks, either by washing, bleaching, ironing, and drying them until they were blank and fit to use or by simply crossing out the name of the payee. Then he’d take the checks to a store, pose as the accountholder, and use them to buy stuff. Lastly, he’d return to the store and return the merchandise for cash.

At trial, the defendant requested a jury instruction that, to be guilty of bank fraud, he must have intended to defraud a bank, not just a store or accountholder. The trial court denied that instruction, and the defendant was convicted under § 1344(2).

On appeal, he argued that if the statute were not read to require a specific intent to defraud a bank then it could potentially apply to every run-of-the-mill fraud that happened to involve a check. In fact, it would even apply if the check itself were perfectly valid, as when a guy sells you a knock-off handbag that you think is Louis Vuitton, and you hand him a check. This result, the defendant argued, would greatly expand the criminal jurisdiction of the federal government into areas traditionally reserved to the states.

The Court disagreed. It ruled that the statute had two clauses for a reason, and defendant’s interpretation would make them redundant because § 1344(1) already required a specific intent to defraud a bank. The Court agreed that § 1344(2) was not a “plenary ban on fraud” that applied to every “pedestrian swindle,” but it held that the statute was limited to cases in which a defendant schemed to obtain money or property “by means of” a misrepresentation, so that his false statement was “the mechanism naturally inducing a bank” (or its custodian) to part with money. The false statement, in other words, must “reach the bank,” which would not happen in the knock-off-handbag example.

That’s all good and well, but the Court’s decision still potentially converts every bad-check case into a federal offense. Despite the Court’s consensus that § 1344 should not be read that way, the only things standing in the way may be the resources and discretion of federal prosecutors.

When Money-Laundering Laws Become “Smurfin’ Ridiculous”

While we’re on the subject of money laundering, let’s talk about “smurfing.”

That’s slang for the term “structuring,” which refers to the purposeful act of breaking up larger financial transactions into smaller amounts in order to avoid federal reporting requirements. For example, the Bank Secrecy Act requires banks to report any deposits, withdrawals, or transfers of more than $10,000. So, if you’re a discreet drug dealer who wants to deposit $100,000 in your bank account, you might decide to break up that deposit into $9,999 increments so that your bank doesn’t go notifying the federal government. If you did, you might think you’re being clever, but you’re probably not, because you’d be guilty of a felony punishable by fines and up to five years in prison. (Not to mention, the government would likely catch wind of it anyway because your deposits would probably cause the bank to generate a suspicious activity report.) If you did it while violating another federal law or as part of a pattern of illegal activity involving more than $100,000 in a 12-month period, your maximum sentence would rise to ten years.

So why can federal structuring laws be smurfin’ ridiculous? Because it’s not illegal to deposit $9,500 (or even $9,999) in your bank account for cryin’ out loud. It’s only illegal to do it because you don’t want your bank to report the deposit to the government. But even then, it doesn’t matter if you didn’t know that doing so was a crime, or if you weren’t trying to cover up any criminal activity, or if you’d earned all the money legitimately, or if you reported every penny of it at tax time. You’d still be guilty. And it gets worse, because if the government suspects you of structuring, it can apply the civil-forfeiture laws to seize all your money or other assets, even if it never charges you with the crime. See 31 U.S.C. § 5317(c)(2).

For examples of government overreach that ruined or nearly ruined people’s lives, consider these two.

In one case, a Russian immigrant was trying to buy a house, but two weeks before closing, she learned that her bank in Russia wouldn’t wire the purchase money because of a mix-up over her married and maiden names. Scrambling, she spent the next two weeks withdrawing her maximum daily limit from every ATM in town and depositing it in her domestic bank account. She was charged with structuring, convicted of a felony, and ordered to sell her home and surrender the proceeds to the government. She finally got the conviction reversed on appeal but only because prosecutors had converted her trial into a general referendum on her character by asking her a bunch of unfair, unrelated questions on cross-examination. I’m sure she thought it was all worth it in the end.

In the second case, a father and daughter were running a small but successful grocery store in suburban Michigan. Their insurance only covered losses up to $10,000, so they would make frequent deposits below that threshold. Sure enough, they were investigated, and the government went after them, seizing all the money in their bank account and commencing forfeiture proceedings to keep it. The government finally backed off, but only after a public-interest law firm roused up publicity about the case.

The takeaway? If you’re a gas station, convenience store, used-car dealership, or another business that typically handles a lot of cash, take care. Here’s what one lawyer had to say about it:

“The emphasis is on basically seizing money, whether it is legally or illegally earned. It can lead to financial ruin for business owners, and there’s a potential for abuse here by the government, where they use it basically as a means of seizing money, and I think we’ve seen that happen.”

Cash, it turns out, is not always king.

Cleanliness is Next to Godliness for George, Tom, Abe, Alex, Andy, Ulysses, and Ben

In common parlance, money laundering is the process of taking illegally-gained, “dirty” money and making it appear legal or “clean.”

Who needs to wash money? A classic case is the drug dealer who’s sitting on a pile of cash but can’t very well explain where he got it from. The same concept, however, applies to other unlawful activity like financial frauds, computer crimes, alien smuggling, arms trafficking, public corruption, and illegal gambling.

How does one wash money? Although there are many ways to skin this cat, the process generally involves three steps:

  1. Introducing the dirty money into the financial system somehow (e.g. by making a deposit, buying an asset, making a loan, or funding an investment);
  2. Moving the money around through additional transfers or transactions to create confusion and make it harder to identify the original source of the funds; and
  3. Disbursing the money back to the launderer through a final set of seemingly legitimate transactions.

Money-laundering laws, however, apply to a broader range of conduct than that. They don’t just apply when people move around dirty money to disguise its source, nature, control, ownership, or location. They also apply when people move dirty money to promote the unlawful activity (e.g. by reinvesting the proceeds into it); to evade taxes; or to avoid currency-reporting requirements. See generally 18 U.S.C. § 1956; 31 U.S.C. §§ 5316, 5324, & 5332. They even apply when people knowingly engage (or attempt to engage) in any transaction involving more than $10,000 in dirty money, regardless of intent. 18 U.S.C. § 1957. And they apply to schemes to mask the source of legal money that is intended to support terrorism.

Below are a few of the important money-laundering laws we’ve enacted and their highlights.

Bank Secrecy Act (1970)

  • Required banks to keep adequate books and records to identify money flows and laundering.
  • Required banks to report cash transactions over $10,000 through a Currency Transaction Report (or CTR).

Money Laundering Control Act (1986)

  • Made money laundering a federal crime.
  • Prohibited the structuring of transactions to evade a CTR filing.
  • Introduced civil and criminal forfeiture for violations of the Bank Secrecy Act.

Annunzio-Wylie Anti-Money Laundering Act (1992)

  • Required banks to file suspicious activity reports (or SARs) if they know, suspect, or have reason to know or suspect that a transaction involves criminal activity.

Money Laundering Suppression Act (1994)

  • Regulated “money services businesses” (MSBs) that convert or transmit money (like Western Union, Check ‘n Go, or even a convenience store that issues money orders).
  • Criminalized the operation of an unregistered MSB. See, e.g., 18 U.S.C. § 1960.

Uniting and Strengthening America by Providing Appropriate Tools to Restrict, Intercept, and Obstruct Terrorism (USA PATRIOT) Act (2001)

  • Criminalized the financing of terrorism.
  • Facilitated government access to bank records.
  • Increased the civil and criminal penalties for money laundering.

FDIC Jumps Into the Fray of LIBOR Manipulation

Last Friday, the Federal Deposit Insurance Corporation filed a lawsuit against 16 of the world’s biggest banks over their alleged rigging of the LIBOR interest rate. LIBOR, of course, stands for the London Interbank Offered Rate, an average, base interest rate that sets the benchmark for many commercial interest rates around the world. (Think home mortgages, car loans, student loans, and derivatives.) The LIBOR is supposed to reflect the rate at which large banks lend to each other, and it’s based on data that the banks report daily. But what if it’s rigged?

The problem is that even small fluctuations in the LIBOR can significantly affect borrowing costs and investment returns for people and businesses whose activities link to it. So if the underlying data that is used to calculate the LIBOR is manipulated, then some bankers and traders will hit pay dirt on their LIBOR-related bets while others are left holding the bag.

In the FDIC case, the agency is suing on behalf of 38 banks that it took over after they went bankrupt during the financial crisis. The agency is alleging that these banks incurred a lot of their losses from certain interest-rate-sensitive financial products that were sold to them by the bigger banks, and their losses were compounded by the bigger banks’ manipulation of the LIBOR.

The FDIC lawsuit is the latest in a series of civil, regulatory, and criminal actions that span the Atlantic and began in the throes of the financial crisis, ripening around 2012. They include criminal investigations by the Justice Department in the U.S. and the Serious Fraud Office in the U.K. that have resulted in criminal charges on both sides of the pond.

Indeed, prosecutors are negotiating a mild turf war to divvy up defendants, and they plan to charge additional cases over the next year.

Lawful Marijuana Businesses Should Be Able to Bank, Says U.S. Attorney General

Three cheers for common sense. Speaking at the University of Virginia last Thursday, Attorney General Eric Holder said that lawful marijuana businesses should have access to the American banking system and that the government would soon offer rules to guide their relationships with banks.

Let’s hope so, because that is the only common-sense way to go about it, and for the twenty states that have legalized marijuana in some form or fashion, the alternative is something close to sabotage. If we are going to permit marijuana businesses to operate but then paint them in a corner by forcing them to hoard cash under their proverbial mattress, we should not feign shock or dismay if, for example, they come to rely on guns for protection, or if we leave potential tax revenue on the table, or if other ills follow as a result. “You don’t just want huge amounts of cash in these places,” according to Mr. Holder. “There’s a public safety component to this.”

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