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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.

On September 27, 2016, the Securities and Exchange Commission (“SEC”) filed a complaint against oil services company Weatherford International PLC (“Weatherford”), consequently garnering a $140 million settlement related to fraudulent income tax accounting (the “Complaint”).  According to the Complaint, Weatherford issued false financial statements between 2007-2012 inflating earnings by more than $900 million.  Weatherford misrepresented both its earnings per share (“EPS”), and effective tax rate (“ETR”), and created a misperception for investors that a unique tax structure had been designed which provided it with a superior international tax avoidance strategy, when no such advantages existed.  James Hudgins (“Hudgins”), Weatherford’s Vice President of Tax and Darryl Kitay (“Kitay”), Weatherford’s Tax Manager (collectively the “Defendants”) have agreed to settle charges that they orchestrated this fraud. Weatherford’s market cap is currently $5.04 billion, with the $140 million fine representing 2.7% of total valuation.

Weathorford is charged with: violation of Securities Act Section 17(a) and the Securities and Exchange Act of 1934 (the “Exchange Act”) Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B), and Rules 10b-5, 12b-20, 13a-1, 13a-11, and 13a-13 thereunder.  Defendant Hudgins is charged with: (i) willfully violating Securities Act Section 17(a), Exchange Act Sections 10(b), and 13(b)(5) and Rules 10b-5(a) and (c), 13b2-1 and 13b2-2 disseminated thereunder; (ii) orchestrating Weatherford’s violations of Securities Act Section 17(a), Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and (B), and Rules 10b-5, 12b-20, 13a-1, 13a-11, and 13a-13 promulgated thereunder; and (iii) willfully violating federal securities laws pursuant to Section 4C of the Exchange Act and Rule 102(e)(1)(iii) of the Commission’s Rules of Practice. Defendant Kitay, due to his fraudulent conduct, faces charges of: (i) willfully violating Securities Act Section 17(a), Exchange Act Sections 10(b) and 13(b)(5), and Rules 10b-5(a) and (c), 13b2-1 promulgated thereunder; (ii) instigating Weatherford’s violations of Securities Act Section 17(a), Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and (B), and Rules 10b-5, 12b-20, 13a-1, 13a- 11, and 13a-13 promulgated thereunder; and (iii) willfully violating the federal securities laws pursuant to Section 4C of the Exchange Act and Rule 102(e)(1)(iii) of the Commission’s Rules of Practice.

Weatherford was formed in 1998 with the merger of two companies, and immediately embarked on a strategy of aggressive expansion.  This directive was achieved largely through hundreds of acquisitions of smaller natural gas equipment and service providers, purchases that Weatherford financed by issuing corporate bonds.  The SEC alleges that this unchecked growth was largely responsible for the lack of effective internal controls governing income tax accounting.  In 2002, Weatherford completed an inversion to become incorporated in Bermuda, in order to be headquartered in a place of 0% tax jurisdiction.  From 2003 through 2006, Weatherford continued to embark on ETR reduction strategies through tax hybridization schemes, including shifting debt assets to high tax jurisdictions such as the US and Canada, and equity assets to low or zero tax jurisdictions.  These strategies reduced Weatherford’s ETR from 36.3% in 2001 to 25.9% in 2006.  Each percentage point reduction in Weatherford’s ETR translated to an approximately $0.02 to $0.03 gain in Weatherford’s EPS, giving the company more latitude to issue debt and make more acquisitions to increase revenue.

On September 26^th, 2016, the Securities and Exchange Commission (“SEC”) filed a Complaint for Injunctive and Other Relief against Craig V. Sizer (“Sizer”) and Miguel Mesa (“Mesa”) (collectively referred to as the “Defendants”), for violating federal securities laws (the “complaint”).  The Defendants specifically violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 (“the Exchange Act”), Rule 10b-5 thereunder, and Section 15(a) of the Exchange Act.  The Complaint alleges that the Defendants broke these antifraud and broker-dealer registration laws by deceiving over 600 investors of approximately $20 million and misappropriating the vast majority of these funds for personal use.

According to the Complaint, beginning in 2009 and continuing through August 2015, Sizer, former co-founder and former Chief Executive Officer of Sanomedics Inc. (“Sanomedics”) and former President and Board Director of Fun Cool Free Inc. (“Fun Free Cool”) (collectively referred to as the “Companies”), orchestrated the fraudulent sale of shares in both Companies.  This fraud involved equipping sales agents with materially misleading statements in relation to how investor capital would be spent.  According to the Complaint, Sizer hired Mesa to market these companies to investors.  Mesa oversaw boiler-room operations for sales agents, and provided them with scripts used to cold call prospective investors and fraudulently convince them to purchase shares in Sanomedics and Fun Cool Free.

The Complaint alleges, Sizer and Mesa used these tactics on many elderly, and financially illiterate investors.  They hired and directed Seven (7) or more sales agents, who purchased lists of contact numbers for individuals they believed possessed resources to invest, such as those who recently inherited sums of money.  Mesa told these sales agents that they did not need to be registered in order to sell stock.  These agents sold restricted stock to investors, ranging in prices from $0.05-$2.50 per share, while promising them outlandish profits and making untrue statements that they were buying the stock at a discount to the market.  Investors were also told that no fee or commission would be charged, while in actuality, Mesa paid 15-20% of the funds he misappropriated to the sales agents in the form of commissions.  Sizer was not, and never has been, registered as a broker despite courting investors personally.  Additionally, in 2004 and 2006 Mesa was charged in separate civil injunctive actions by the Commodities Futures Trading Commission (“CFTC”) for fraudulent activity in relation to trading futures and contracts. He was permanently barred from the commodities industry.  Both currently and during the relevant time period, Mesa was not registered as a broker or associated with a broker-dealer.

On September 28^th, 2016, the Securities and Exchange Commission (“SEC”) charged a Peruvian brokerage firm manager and two lawyers with making trades that were informed by insider knowledge regarding the imminent merger of two mining companies (“The Complaint”).  The SEC alleges that the Defendants Nino Coppero del Valle (“Valle”) and Julio Antonio Castro Roca (“Roca”) (collectively the “Defendants”) conspired to trade on information regarding the tender offer that Canadian-based Hudbay Minerals (“Hudbay”) made to acquire shares of Arizona-based Augusta Resource Corp. (“Augusta”).  The Complaint charges the Defendants with violating the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 (“The Exchange Act”).   In addition, Valle, Roca, and broker affiliate Ricardo Carrion (“Carrion”) are charged with violating clauses regarding a stay on trading ahead of the announcement of a tender offer contained in Exchange Act Section 14(e) and Rule 14e-3.

Valle was an attorney at Hudbay who was privy to the acquisition, and relayed this knowledge to his close friend and fellow attorney Roca, who then allegedly acted on this information by making trades through a brokerage account he set up in the British Virgin Islands.  This account was allegedly registered offshore in order to avoid regulatory scrutiny about the timing of the trades and their connection to insiders.  The Complaint alleges that these unlawful trades netted Valle and Roca over $112,000 in illegal profits.

While researching how to make trades untraceable, Valle allegedly sourced an acquaintance Carrion—an employee at a Peruvian brokerage House—and gave him insider information in exchange for advice on obscuring the trades that his friend Roca intended to make.  Carrion’s brokerage house made a profit of $73,000 off of the insider information that Hudbay was intending to acquire a large percentage of Augusta and its operations.  In a warning to others and a reference to the SEC’s cross border enforcement powers, Andrew M. Calamari, Director of the SEC’s New York Regional Office, told the press: “[T]ry as they might, overseas traders shouldn’t presume they can cover their tracks to avoid detection and scrutiny from U.S. law enforcement when they violate insider trading laws.”

The Libyan Investment Authority (“LIA”) is in a current litigation battle with Goldman Sachs (“Goldman”) regarding Goldman’s potential exploitation of the relative inexperience and financial illiteracy of LIA managers. The Complaint alleges Goldman advised LIA to place trades that incurred enormous losses, while yielding Goldman approximately $200 million in fees.  LIA is suing Goldman for $1.2 Billion in losses, with the trial beginning in June 2016 in London.  LIA is arguing that its investment staffers never understood the complexity of the deals Goldman sold them, and were exploited through Goldman’s use of misleading marketing materials and lavish gifts that were bestowed on staffers.  LIA staffers gave statements saying that they had never heard of “derivatives,” “Goldman Sachs,” “options,” or “due diligence” while attempting to show the court the extent of their naiveté, despite the fact that they managed a multi-billion-dollar fund.  Goldman disputes the degree of LIA’s ineptitude and naiveté, arguing that LIA “[u]nderstood at all times that [our representative] was a salesman, and that his job was to sell investments to the LIA from which [Goldman] could make money.”  Furthermore, Goldman argues it is clear that LIA “[u]nderstood the disputed trades and entered into them of their own volition.”

Youssef Kabbaj (“Kabbaj”), a Goldman Sachs securities salesperson, almost singlehandedly wooed in excess of one billion dollars from the LIA in the form of complex derivative investments.  Kabbaj, an MIT engineering graduate from a wealthy and prominent African family, joined Goldman’s London office in 2006.  While assigned to a sales team covering Africa, a desk that posted little to no profit at that time, Kabbaj shrewdly identified Libya as an “elephant”—an incredibly wealthy petro state client with enormous coffers that could be persuaded to buy securities.  Despite being one of the wealthiest states in Africa, Libya had very few privately owned companies, no credit cards until late 2005, and limited experience with investing.  Kabbaj managed to persuade Mustaga Zarti (“Zarti”), the LIA Deputy Chief Executive, that Libya would miss out if it didn’t buy into the rising bull market.

Consequently, the LIA fund purchased in excess of $2 billion worth of bullish derivative bets on US banks, including Citibank, Lehman Brothers, and the French Utility EDF Group.  In the aftermath of the enormous losses these bets incurred, LIA management stated they were unaware they had purchased synthetic derivatives which, during the rapid devaluation of the 2008 financial crises, entirely wiped out their books, and thought instead they had purchased shares directly.  While synthetic derivatives can take innumerable forms—they can be structured in any way as long as there is a buyer to take the other side of the deal—the instruments Goldman sold to LIA were structured in a particularly risky manner.  If, for example, Citibank’s stock rose, then LIA would get a return on their investment in multiples of their initial purchase, due to the leverage.  If, however, Citibank’s stock fell, even incrementally, LIA’s entire book would have been wiped out.

On September 19, 2016, the SEC filed an Order Instituting Public Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 4C and 21C of the Securities Exchange Act of 1934 and Rule 102(e) of the Commission’s Rules of Practice, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order against Ernst & Young, Robert J. Brehl, CPA (“Brehl”), Pamela J. Hartford, CPA (“Hartford”), and Michael T. Kamienski, CPA (“Kamienski”) (the “Ernst & Young Order”).  The Ernst & Young Order was one of the first two enforcement actions ever filed by the SEC for auditor independence failures due to improper personal relationships between auditors and their clients’ employees.

Brehl served as Chief Accounting Officer of one of Ernst & Young’s public company clients (the “Issuer”) from January 2006 through July 2014, and is a certified public accountant (“CPA”) who resides in Kentucky.  Hartford initially served as the engagement partner and then as the coordinating partner on the Ernst & Young engagement team that provided audit and review services to the Issuer (the “Engagement Team”) until her termination on July 7, 2014.  Kamienski served as the coordinating partner on the Engagement Team from 2009 to 2013.  Beginning in December 2013, he also served as Ernst & Young’s Global Real Estate, Hospitality & Construction Assurance Leader, and then, in July 2014, as Ernst & Young’s Central Region Assurance Real Estate Market Segment Leader until his resignation in April 18, 2016.

According to the Ernst & Young Order, between March 2012 and June 2014, Hartford and Brehl “maintained a close personal and romantic relationship.”  Specifically, “[t]heir relationship was marked by a high level of personal intimacy, affection and friendship, near daily communications about personal and romantic matters (as well as work-related matters), and the occasional exchange of gifts of minimal value on holidays such as Valentine’s Day and birthdays.”  Further, from early 2013 through June 2014, Kamienski “was aware of facts suggesting a possible romantic relationship between Hartford and Brehl” and “should have identified those facts as red flags but did not” and failed to “raise concerns internally to [Ernst & Young’s] U.S. Independence group.”  During this time, Ernst & Young continued to maintain that it was an independent auditor on the Issuer’s financial statements and filings with the SEC.

On September 8, 2016, the Securities and Exchange Commission (“SEC”) filed a Complaint and Jury Demand with the United States District Court for the Southern District of New York (“Complaint”) against Brian S. Block (“Block”) and Lisa Pavelka McAlister (“McAlister”) relating to an alleged 2014 fraud that inflated the value of the largest publicly traded net lease real estate investment trust (“REIT”), American Realty Capital Properties, Inc. (“American Realty Capital”) (NASDAQ ticker symbol “ARCP”) (n/k/a VEREIT, Inc.).

Block was the CFO of American Realty Capital until he resigned on October 28, 2014.  He is a 44 year old certified public accountant (“CPA”) who is licensed and resides in Pennsylvania.  McAlister was appointed Chief Accounting Officer of American Realty Capital in November 2013, and subsequently became Principal Accounting Officer in May 2014 until she resigned on October 28, 2014.  McAlister is a 52 year old CPA who is licensed in New York and who resides in Massachusetts.  According to the Complaint, American Realty Capital reported total assets of approximately $21 billion during the relevant time period.

Publicly traded issuers must follow generally accepted accounting principles (“GAAP”) as set forth by the Financial Accounting Standards Board, and as adopted by the SEC.  One of the metrics captured is the net income and earnings per share (“EPS”).  According to the Complaint, American Realty Capital reported a non-GAAP metric, Adjusted Funds from Operations (“AFFO”), which is a metric typically used by most REITs.  According to the Complaint, and as defined by the National Association of Real Estate Investment Trusts, AFFO is an adjusted version of “a standardized metric of REIT operating performance.”

On August 10, 2016, the Securities and Exchange Commission (“SEC”) filed a complaint against Merrill Robertson, Jr. (“Mr. Robertson”), Sherman C. Vaughn, Jr. (“Mr. Vaughn”), and Cavalier Union Investments, LLC (“Cavalier Union”) (collectively the “Defendants”), alleging that they violated Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933 (the “Securities Act”), as well as Section 10(b) of the Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder (the “Complaint”).

Mr. Robertson was a professional football player for the Philadelphia Eagles, and is currently a co-owner and Managing Principal of Cavalier Union who previously held Series 7 and 66 securities licenses between April 2008 and December 2009.  He is a resident of Chesterfield, Virginia.  Mr. Vaughn, along with Mr. Robertson, is a co-owner and Managing Principal of Cavalier Union.  Mr. Vaughn has never been registered with the SEC, and has filed for personal bankruptcy four times, which had not been disclosed to investors.  Mr. Vaughn is also a resident of Chesterfield, Virginia.  Cavalier Union is based in Midlothian, Virginia, and was formed in February 2010.  Cavalier Union is not registered with the SEC.

According to the Complaint, the Defendants bilked more than $10 million from over 60 investors by fraudulently inducing them to invest in Cavalier Union promissory notes that purported to pay a fixed rate of return of between 10 and 20 percent by investing in “cash-producing tangible assets”, but were in fact part of a Ponzi scheme that allowed Mr. Robertson and Mr. Vaughn to live lavishly.  These investors were comprised of “unsophisticated senior citizens and former football coaches, donors, alumni, and employees of schools [Mr. Robertson] had attended”, and Mr. Robertson and Mr. Vaughn “lied about their sophistication, the safety and security of the [Cavalier Union] promissory notes, and [Cavalier Union’s] financial condition” and “claimed that [Cavalier Union] used investor money to invest in a broad range of business ventures, such as restaurants, real estate, alternative energy, and assisted living facilities.”