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On January 25, 2017, the Securities and Exchange Commission (“SEC”) filed a complaint in the United States District Court for the District of Massachusetts against Michael J. Breton (“Breton”), and his investment advisory firm Strategic Capital Management (“SCM”), (collectively the “Defendants”) for engaging in “cherry-picking,” and defrauding investors of approximately $1.3 million in proceeds (the “Complaint”).  At all times during the fraud, Breton was under a fiduciary duty to SCM clients, and had made promises that his personal trading activities would not disadvantage SCM investor returns—statements that time proved to be misleading and false.  The Defendants actions violated several antifraud statutes and SEC rules, including Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b- 5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 (“Advisers Act”).

Cherry Picking occurs in many forms, but its basic structure is as follows. An investment advisor who is authorized to buy securities on behalf of investors purchases a stock, and then defrauds investors by waiting to see whether the stock goes up or down before allocating the trade to himself or his clients’ accounts depending on the profitability observed after the fact.  The Complaint notes that in this instance, Defendants allocated more than 200 unprofitable trades to client brokerage accounts, while allocating more than 200 profitable trades to Breton accounts, after their gains were realized.

SCM is a limited liability investment advisory firm, registered in Massachusetts since 2000. Breton founded SCM in 1999, and served as the Managing Partner and Chief Compliance officer of SCM. Breton used two different brokerage firms to place orders through.  According to the Complaint, Breton purchased securities through two master accounts, and they allocated these securities to various client accounts, or accounts he himself owned, depending on the profitability outcome of these trades.  The Complaint alleges that this fraudulent cherry picking activity began in January 2010, and continued through March 2016.  The Complaint notes that Breton would employ a familiar strategy of buying several stocks right before their earnings reports were released, then as soon as the earnings call was made, would immediately thereafter allocate winning stocks to his accounts, and stocks that missed earnings or revenue projections to his clients’ accounts.

Twitter investors are bringing actions against the social media giant on grounds that employee compensation structuring has depressed stock values, slowed company growth, and incurred investors enormous losses.  This class action has been brought by investors Johnny Hosey (“Hosey”) and George Shillliare (“Shillaire”) (collectively, “Plaintiffs”).  The suit was filed in San Mateo County Superior Court, CA, taking aim against Twitter, its executives and several prominent investment banks.  The suit accuses the social media company of lying in its public disclosures when it went public in November 2013.  A company of Twitter’s size faces numerous suits on a regular basis, fielding a wide variety of complaints. This case is unique, however, in that it is a class action, and specifically addresses Twitter’s unusual employee compensation structures that claimants allege contributed to damages.

Plaintiffs allege that Twitter’s employee compensation package devalued the company through the following mechanism: employees were compensated largely with stock, with it representing a disproportionate percentage of their compensation package relative to other tech companies of Twitter’s size.  As Twitter stock fell, due to issues with user growth, ad monetization, and management uncertainty, Twitter’s stock fell.  As the stock fell, it became harder to retain or attract tech talent, given that the majority of compensation was stock based.  As talented managers left for better opportunities, stock price fell further, and the cycle repeated itself.  The complaint summarizes this mechanism as follows: “[u]ltimately a ‘death spiral’ ensues: departing employees weaken the company’s competitiveness; a less competitive company results in lower user growth which hurts the growth of advertising revenue; the company’s poor performance causes its stock price to fall; a falling stock price results in reduced compensation to current and prospective employees causing them to leave for better prospects, which in turn further weakens the company.”

Most litigation to date levied at Twitter allege poor stock performance due to actionable management negligence, or fraud in regard to user growth metrics being exaggerated, or stock decline due to the company’s inaction regarding user bullying leading to bad public relations.  This is the first suit of its kind from investors that specifically seeks damages in relation to management decisions regarding employee compensation.  The suit will likely cite findings and actions made in suits brought by Twitter employees themselves, who have sued their employer alleging they were misled as to how much stock growth would increase their compensation packages.  Twitter made its Initial Public Offering (“IPO”) November 2013 at $28 a share.  It is currently fluctuating between $14-18 a share.  By focusing on employee retention and compensation this lawsuit opens a new front in regards to analyzing Twitters problems.

On December 19^th, 2016 the Securities and Exchange Commission (“SEC”) filed a Complaint (the “Complaint”) against Defendants Platinum Management, LLC (“Platinum Management”), Platinum Credit Management, L.P.(“Platinum Credit”), Mark Nordlicht (“Nordlicht”), David Levy (“Levy”), Daniel Small (“Small”), Uri Landesman (“Landesman”), Joseph Mann (“Mann”), Joseph San Filippo (“San Filippo”) (collectively the “Platinum Defendants”), and Jeffrey Shulse (“Shulse”) (all collectively “Defendants”), charging Defendants with a complex, multi-pronged, fraudulent scheme to inflate returns to investors, and cover up massive losses and liquidity problems.

Prosecutors allege that Platinum Defendants collectively engaged in one of the largest investment frauds since Bernie Maddoff’s elaborate Ponzi scheme was uncovered in 2008.  On paper, Platinum Management averaged compound returns of 17% a year from 2003 to 2015, making it one of the best performing New York based hedge funds in the industry.  The Complaint draws question to Platinum Management’s 17% yearly return, given that many positions were fraudulently overvalued, and the fund engaged in heavy high interest short term borrowing to pay back costumer redemptions. The true performance of the hedge fund won’t be found out until the entire fund is liquidated and the SEC completes its investigation.

Platinum Management permitted more liquidity to investors then many of their competitors, permitting freedom to redeem funds on 60 or 90 days’ notice.  The firm heavily advertised this advantage; the capacity for the firm to rapidly liquidate positions.  The Complaint alleges that in reality, Platinum Management was facing an urgent liquidity crises, brought on by several large illiquid investments in oil production companies.  In as early as 2012, internal correspondence among Platinum Management officials spoke of fund redemptions that were “relentless,” and a “code red,” meanwhile continuing to conceal from current and prospective investors the precarious position of the fund.

On December 28, 2016, Lax & Neville LLP, a leading national securities arbitration law firm, won a FINRA arbitration award on behalf of Anthony F. Garvin, a former investment banker at Burnham Securities, Inc.  The investment banker had brought claims for breach of contract, violation of the New York Labor Law, conversion, unjust enrichment, and quantum meruit against Burnham Securities, Inc. and David S. Gilio, a former investment banker at Burnham in connection with an investment banking fee.  Garvin and Gilio, with Burnham’s approval, agreed to collaborate on investment banking deals, and to share the commission for all deals that originated from their joint efforts, depending upon who sourced the respective deal.  When one deal closed, Garvin was not paid the full investment banking fee due to him.

A FINRA arbitration panel found Burnham and Gilio jointly and severally liable and ordered them to pay Garvin more than half a million dollars, including the full amount of compensatory damages he requested in the amount of $348,125 plus interest at the rate of 9% per annum from December 15, 2016 until the award is paid in full, pre-award interest in the amount of $121,352, costs totaling $5,721, and attorneys’ fees in the amount of $90,000.  “The Panel awarded attorneys’ fees as all parties requested attorneys’ fees.”  See Award.

Lax & Neville LLP has extensive experience representing investment bankers and financial services professionals in compensation disputes.   To discuss this arbitration award, please contact Barry R. Lax or Sandra P. Lahens, Esq., at (212) 696-1999.

The Securities and Exchange Commission (“SEC”) issued public administrative and cease-and-desist proceedings pursuant to Section 8A of the Securities Act of 1933 (“Securities Act”) and Sections 15(b) and 21C of the Securities Exchange Act of 1934 (“Exchange Act”) (the “Order”) against EZTD Inc. (“EZTD”).  Israeli-based EZTD, a brokerage firm, offers binary options to US customers.  According to the Order, EZTD sold securities while not regulated to do so and made certain misleading or materially false statements on its subsidiary websites “eztrader” and “globaloption” regarding the profitability and risks associated with investing in binary options.

The Order states that EZTD willfully violated Sections 5(a) and 5(c) of the Securities Act and Section 15(a)(1) of the Exchange Act, and Sections 17(a)(2) of the Securities Act.  The charges brought by the SEC against EZTD relate to EZTD (1) selling securities over the internet without registering the securities, (2) failing to register as a broker-dealer while selling securities, and (3) misleading investors by failing to disclose that there was a significantly greater potential for investors to lose money than to turn a profit.  Additionally, the Order notes that only 2.8% of EZTD’s customers turned any kind of profit and EZTD misstated or omitted the true financial risks associated with investing in the firm’s binary options.

Binary options are derivatives, meaning that they are not actually bought or sold as an asset themselves, but rather are a fixed wager on the outcome of an underlying security.  Usually this bet takes the form of a wager on whether or not the price of an asset will rise or fall below a specified price by the time the binary option expires.  Winnings are predetermined, usually 80% of the initial bet, and losses generally result in forfeiture of the entire bet.  The time frame for these binary option derivative trades is short, with many of the options offered allowing 60 second time frame wagers.  A binary option does not give the owner the right to purchase or sell the underlying asset upon which the binary option is contingent, or to purchase or sell the binary option itself.

On October 20, 2016, the Securities and Exchange Commission (“SEC”) instituted cease-and-desist proceedings pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”), against FMC Technologies, Inc. (“FMCTI”), Jeffrey Favret, CPA (“Favret”) and Steven K. Croft, CPA (“Croft”) (collectively, “Respondents”) and additionally instituted public administrative proceedings against Favret and Croft pursuant to Section 4C of the Exchange Act and Rule 102(e)(1)(iii) of the Commissions’ Rules of Practice (SEC actions collectively the “Order”).  The Order alleges that the violation of Generally Accepted Accounting Practices (“GAAP”) occurred in relation to manipulation of funds that were earmarked for FMCTI’s paid time off policies (“PTO”).  FMCTI agreed to pay a penalty of $2.5 million in relation to the SEC charges, and Favret and Croft agreed to pay $30,000 and $10,000, respectively.

FMCTI is an operations and equipment provider to the energy industry, designing and manufacturing service systems and products such as: offshore production and processing systems, surface wellhead systems; high pressure pumps and fluid control equipment; measurement solutions and marine loading systems for the oil and gas industry.  FMCTI is a Fortune 500 company that trades on the New York Stock Exchange, and its capabilities are divided into three business reporting segments: Subsea Technologies; Surface Technologies; and Energy Infrastructure.  Favret was the controller at Energy Infrastructure, and Croft was the controller of Automation & Control (“A&C”), a business unit that was acquired by Energy Infrastructure.  After the acquisition, Favret became segment controller and Croft became business unit controller.

The Order noted that FMCTI has an unusual PTO policy, with employees earning their PTO days on January 1 of each new year, rather than accruing them by month or pay period.  For example, if twelve (12) days of PTO are provided per year at FMCTI, an employee could conceivably take off the first twelve (12) days of January, leaving no remaining PTO days for the rest of the year.  The Order acknowledged that FMCTI structured its PTO policy to benefit employees as it gave them flexibility to use their PTO days in chunks. Unfortunately, it created a larger capital requirement to be held at the beginning of each calendar year.  Because, according to GAAP standards, FMCTI was required to establish a reserve for its full-year PTO liabilities as of January 1.  FMCTI also allowed employees to roll over unused PTO days from one year to the next.  Funds to pay these days were also required to be held in the account in addition to full year PTO liabilities.

On October 16, 2016, the Securities and Exchange Commission (“SEC”) instituted cease-and-desist proceedings (the “Order”) against mobile phone application (“App”) Forcerank LLC (“Forcerank”) pursuant to violations of Section 8A of the Securities Act of 1933, and Section 21C of the Securities Exchange Act of 1934.  In response to the Order, Forcerank has submitted an Offer of Settlement (the “Offer”), without admitting or denying any wrongdoing but accepting SEC jurisdiction over regulation.

According to the Order, Forcerank is an App that allows users to attempt to predict the outcome of a basket of securities by ranking these securities based on their performance relative to each other.  While this usage may have functioned as a “game,” it was in essence an over-the-counter derivative trade: a payout was to be made not on the underlying value of any of these securities, but on a “derivative of” their value, in this case their value relative to each other.  The SEC alleges Forcerank structured the game in week-long segments, during which time players won points for each security for which they guessed the price.  Based on the accuracy of their prediction, at the end of the competition players who were most accurate received cash prizes.  Forcerank kept 10% of the entry fees, and maintained a data set of user behavior and bets that it intended to sell to hedge funds or other wealth managers as insight into crowd perception of certain securities.  Forcerank was a creation of Estimize, a private New York based company that collects and sells data about securities and trading, primarily through developing websites and Apps through which it can crowdsource user behavior.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) specifically regulates the derivatives market.  Whether or not the creators of Forcerank were aware that their product constituted a financial derivative is not material to the fact that they were required to file an effective registration statement covering their derivative offering with the SEC.  Given that Dodd-Frank requires that derivative type transactions occur only on exchanges, subject to the highest level of regulation and cleared with registered clearing agencies, so that investors are provided with public price discovery mechanisms, it is unlikely Forcerank would be able to operate its “swap” trading game even if it had registered properly.  Pursuant to reforms under Dodd-Frank that sought to limit the sale of security-based swaps, entities that are not “eligible contract participants” may not engage in this type of derivative trading.  In order to qualify as an “eligible contract participant,” among many categories required are monetary thresholds, mandating that an individual need to have at least $5 million invested on a discretionary basis to qualify as a seller of security-based swaps.

On September 29^th, 2016 the Securities and Exchange Commission (“SEC”) announced that International Game Technology (“IGT”), a casino-gaming company, would pay a penalty of $500,000 for dismissing an employee (the “Whistleblower”) who raised questions about its cost accounting model. The SEC alleges this termination occurred as retaliation for the Whistleblower investigating company accounting practices (the “Complaint”).  This case is the first stand-alone whistleblower retaliation case without charges of other misconduct.   On further investigation it was revealed that IGT did conform to Generally Accepted Accounting Practices (“GAAP”) and was not engaging in any illegal activities. However, IGT is being fined for violating whistleblower retaliation provisions in Section 21F(h) of the Securities Exchange Act of 1934 (the “Exchange Act”).  This fine was submitted pursuant to an Offer of Settlement (the “Offer”), without admitting or denying the findings contained within the Complaint.

The SEC protects whistleblowers from retaliation by their employers.  The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), which became effective in July 2010, contains new whistleblower provisions that provide substantial incentives and protections for individuals who voluntarily provide information to the SEC concerning securities law violations.  Securities violations that can be reported by whistleblowers to the SEC include the following: unregistered offer or sale of securities; insider trading; market manipulation; theft or misappropriation of funds or securities; bribery of foreign officials; filing false or misleading SEC reports or financial statements; Ponzi schemes; abusive naked short selling; fraudulent conduct associated with municipal securities transactions or public pension plans; and other fraudulent conduct.

IGT is a Nevada based corporation that is a subsidiary of IGT PLC, which is a public limited company that trades on the New York Stock Exchange (“NYSE”) as a foreign private issuer.  The Whistleblower joined IGT in 2008, and prior to his termination on October 30, 2014, had been promoted to the position of Director, overseeing a budget exceeding $700 million.  The Whistleblower was given only positive performance reviews during that time period, and his bonuses were in the highest range allowed for someone of his seniority.  According to the Complaint, the Whistleblower’s supervisors had put him at the top of their “talent planning matrix,” with the potential to be promoted to a vice-president role.

On October 18, 2016, the Securities and Exchange Commission (“SEC”) issued cease-and-desist proceedings pursuant to Section 8A of the Securities Act of 1933 (“Securities Act”), Sections 15(b), and 21C of the Securities Exchange Act of 1934 (“Exchange Act”), Section 203(f) of the Investment Advisors Act of 1940 (“Advisors Act”), and Section 9(b) of the Investment Company Act of 1940 (“Investment Company Act”) against Paul T. Lebel.  Mr. Lebel was a broker and former representative of registered broker-dealer and investment advisor, LPL Financial LLC (“LPL”).  The Order alleges that Mr. Lebel churned client accounts by purposely and excessively trading mutual fund shares and other class A shares that carry large front-end load fees and therefore generate large commissions.  Such shares are intended to be part of a buy and hold strategy, and not traded at a high frequency.  Mr. Lebel has submitted an Offer of Settlement (the “Offer”), in response to the SEC issuance and the SEC has accepted and granted terms for this offer.

Churning occurs when, in pursuit of commissions, a broker causes securities in a customer’s account to be traded at a frequency that does not reflect the customer’s best interest or financial needs. There are three components necessary for a churning ruling to be established: (1) is broker control of trading activity either through direct written trade placement, or through de facto discretionary authority (i.e. the broker recommends to the client which trades to make and the client regularly agreed to every trade recommended); (2) the broker engaged in excessive trading contrary to client investment objectives and risk tolerances; (3) the broker acted with scienter in that he or she willfully engaged in this trading activity with reckless disregard for costumer interests, usually in pursuit of commissions.

A frequent statistical test used in determining whether churning has occurred on an account is the “turnover ratio.”  The turnover ratio is the ratio of the total cost of security purchases made relative to the average monthly dollar amount in the account.  While courts have not defined a specific ratio that constitutes churning, for example, any ratio over six (6) is considered excessive trading, and in conjunction with other evidence such as broker scienter can be grounds for a churning claim.  Another tool used to measure churning is the ‘break-even’ metric: the amount an investment would have to earn in returns in order to cover the fees of placing it.  If an investment has to appreciate by more than 8% to cover fees it is considered excessive trading.  If it has to appreciate by more than 12%, the metric is conclusive evidence of churning.  In summary, if trading transaction costs are high enough that there is little reasonable expectation that the account could achieve a consistent positive rate of return, the broker must justify the trading conducted.  Additionally, while damages on churning are limited to commissions and interest, a plaintiff can bring a claim regarding the suitability of investments (which is often applicable in churning cases, given that brokers will trade whatever securities earn them the highest commissions rather than what suits the financial needs of their client) and additional damages related to trading losses may be awarded.

According to metrics provided by the Financial Industry Regulatory Authority (“FINRA”), $62.1 million of investor awards issued in 2013 went unpaid, due to brokerage houses’ insolvency.  The Public Investors Arbitration Bar Association (“PIABA”) analyzed FINRA arbitration outcomes and found that for every 1 out of 3 cases that yield damages in arbitration, those damages fail to be collected.  Brokerage firms that are insufficiently capitalized, if not outright insolvent, fail to have the resources to pay investors’ damages when sales practice violations or fraud are uncovered.  For investors who feel they may be victims of fraudulent activity, the additional risk of uncollectable damages is increasingly imbedded into their calculation of whether litigation would lead to a win and net financially positive results.

The Center for Financial Services Innovation (“CFSI”) is a wealth management industry support group, with members such as Bank of America, Charles Schwab, Morgan Stanley, and many smaller broker dealers.  CFSI routinely releases marketing statements with direct encouragements for investors to maintain financial health, as well as a safety net and large cushion of savings. CFSI releases metrics on consumer saving habits, showing that a small unexpected expense would cause bankruptcy for a large percentage of Americans.  Yet many CFSI members often fail to ensure that they can cover investor claims themselves.

In 2010, Securities America, was the fifth largest independent brokerage firm in the country with over 1,900 brokers employed.  However, it had a capital reserve requirement of only $250,000.  Given the limited capacity of its insurance, it had hardly any capital on hand to cover additional uninsured claims.  When Securities America sold $400 million worth of private placements which turned out to be Ponzi schemes that subsequently defaulted, it did not have the resources on hand to pay out damages stemming from various awards.  The claims were eventually settled by Securities America’s parent company Ameriprise.  In many instances, low capital reserves and insufficient insurance can be an advantage because it allows for bargaining from a position of weakness.  If engaged in a class action suit, Securities America can threaten to file for bankruptcy and declare themselves insolvent if claimants don’t agree to accept a specific sum of damages.  However, this case illustrates the underlying danger of the broker dealer industry–firms are far more concerned with paying out commissions and keeping the lights on than provisioning for damages owed to investors.