At the Securities Industry and Financial Markets Association’s 20th Anti-Money Laundering and Financial Crimes Conference, Jamal El-Hindi, Deputy Director of Financial Crimes Enforcement Network, stressed the importance of compliance with the Bank Security Act (“BSA”) and anti-money laundering (“AML”) regulations to actors using “new payment technologies,” such as cryptocurrencies. Mr. El-Hindi said the financial sector is in an “evolutionary state” because of emerging alternatives such as virtual currencies. He stressed the need for emerging financial institutions to design systems that withstand “money laundering, terrorist financing, sanctions evasion, human and drug trafficking, and all manner of other illegal activities.” Mr. El-Hindi warned that developers of cryptocurrencies and messaging systems “cannot turn a blind eye to illicit transactions that they may be fostering,” and noted that FinCEN will regulate these emerging systems in accordance with standards that govern existing financial institutions.
Because FinCEN has BSA and AML regulatory authority over entities that are otherwise regulated by the SEC, FINRA, and other self-regulatory organizations, innovators in social media and cryptocurrency should take note of Mr. El-Hindi’s speech, which likely forecasts the direction of FinCEN’s future enforcement. Given FinCEN’s enforcement authority, and the concerns Mr. El-Hindi raised, emerging financial institutions should consider carefully whether they are in fact complying with the existing BSA/AML legal framework.
SEC SETTLES WITH FOREIGN PRIVATE ISSUER ON DISCLOSURE CLAIMS
The U.S. Securities and Exchange Commission recently struck a $5 million settlement with Diageo, a British alcoholic beverage company, to resolve claims that it mislead investors with respect to its financial results. Notably, Diageo’s disclosure violations did not result from an accounting violation. Instead, Diageo failed to disclose that it had been overshipping inventory. From 2014-2015, Diageo pressured distributors to buy products in excess of demand, which allowed the company to report higher growth. As a result of the overselling, distributors held substantial unneeded inventory. Despite its knowledge that the continued overselling was unsustainable, the Company failed to disclose to investors that distributors would likely purchase less product in the future. The SEC concluded that the overshipping of inventory was materially misleading as an omission because it made Diageo’s statements of organic growth misleading. The likely decrease in sales constituted a “known trend or uncertainty,” which Diageo was required to disclose in its annual report.
Diageo’s status as a foreign private issuer makes this recent SEC settlement notable for the additional reason that it confirms that the SEC’s enforcement of disclosure obligations is not limited to United States issuers.
SEC PREVAILS ON FRAUD CLAIMS AGAINST INVESTMENT ADVISOR
On February 13, 2020, a federal district court in the District of Massachusetts granted partial summary judgment to the U.S. Securities and Exchange Commission on fraud claims against an investment firm and its principal. The SEC alleged that Navellier & Associates Inc. (“NAI”) and its founder, Louis Navellier, made representations regarding an investment strategy licensed from another firm, even though they knew that they lacked the information to support those representations.
The court granted summary judgment for the SEC on its claims under Sections 206(1) and (2) of the Investment Advisers Act of 1940. The court rejected the defendants’ argument that they had not marketed the investment strategy, citing undisputed evidence that defendants distributed brochures regarding the strategy and incorporated the statements into their own marketing materials. The court also rejected the argument that statements about historical performance of the strategy, in particular whether it had been back-tested or was based on actual performance, were immaterial. As for scienter (required for the Section 206(1) claim), the court found it undisputed that NAI personnel and Navallier were aware that the marketing was not supported by sufficient data, citing internal emails and documents in which NAI personnel acknowledged that they had not been provided with underlying data regarding the investment strategy, including emails that referenced fraud. The court also noted that despite this knowledge, NAI did not attempt to halt sales or inform clients of the fraudulent statements, which demonstrated an intention to defraud or, at least, a high degree of recklessness.
MINORITY OWNERSHIP AND SELECTION OF MINORITY DIRECTORS ARE INSUFFICIENT TO DEMONSTRATE CONTROL FOR SECTION 20(a) CLAIMS
On February 7, 2020, a federal district court in the District of Delaware dismissed claims against a hedge fund and its Chief Executive Officer under Section 20(a) of the Securities Exchange Act of 1934, finding that the plaintiff failed to adequately allege that the defendants controlled the alleged primary violator. The plaintiff had argued that the hedge fund had actual control over the primary violator because it held a 3.7% minority stock ownership in the company, appointed four directors (a minority) to the board, and allegedly forced resignation of the company’s CEO. The court rejected that argument, holding that “allegations of control are insufficient where the plaintiff merely alleges that the defendant owned a minority stock interest and selected a minority number of directors.” The court also held that the CEO of the hedge fund did not become a controlling person simply by virtue of being a director.
WHEN GIVEN A SECOND CHANCE, INVESTORS MUST ALLEGE NEW FACTS TO SURVIVE DISMISSAL OF FRAUD CLAIMS
On February 7, 2020, a Florida federal judge dismissed, for the second time, a proposed securities class action against Mednax Inc., a healthcare administration company, and its executives. In Cambridge Retirement System v. Mednax, Inc. et al., the investor plaintiff alleged that defendants engaged in a fraudulent scheme to artificially inflate Mednax’s stock price by reporting positive prospective growth for the company, despite contrary industry trends. On October 3, 2019, the court dismissed plaintiff’s claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, holding that the complaint lacked sufficient facts to establish a material misrepresentation or omission and a strong inference of scienter, which are required elements for securities fraud. The court found that plaintiff alleged only statements of corporate optimism and puffery, which are not actionable, and that the alleged statements were also forward-looking and therefore protected by the Private Securities Litigation Reform Act’s safe harbor. In addition, the court found that plaintiff failed to allege that defendants knew that the adverse trends were affecting the continued growth of the company. The October 3 dismissal was without prejudice and the court gave the plaintiff another opportunity to attempt to plead its claims. However, in its February 7 order, the court found that plaintiff’s amended complaint still lacked facts sufficient to satisfy the heightened pleading standard under the PSLRA. In fact, the court found no new factual allegations at all. Rather, the court concluded that plaintiff merely “rearranged, reformatted, and altered which allegations [were] emphasized,” but still failed to allege any facts sufficient to overcome the deficiencies identified by the court in its October 3 order. Because it was clear to the court that the plaintiff could not overcome those same deficiencies, the court dismissed the action with prejudice.