Securities Fraud Enforcement Action Prompts the Question: What Was the Company Smoking?

On March 9, 2017, the SEC charged a California-based marijuana company, Medbox, with securities fraud for falsely reporting “record” revenue numbers to investors and claiming to be a leader in the marijuana industry while a substantial amount of its earnings came from sham transactions with a secret affiliate. According to the SEC’s complaint, Medbox created a shell company called New-Age Investment Consulting to carry out illegal stock sales and used the proceeds from those sales to boost its revenue.

In the first quarter of 2014, nearly 90 percent of Medbox’s revenue was derived from sham transactions with New-Age. Despite this, Medbox issued press releases touting the revenues as record earnings. The company (which has since changed its name to Notis Global) agreed to settle the SEC’s charges for more than $12 million.

In a separate action, on March 13, 2017, the SEC charged an accountant with operating a $1.5 million Ponzi scheme. The SEC alleged that starting in July 2007, Joseph A. Castellano began to solicit investments from clients, claiming he would invest the funds in real estate projects. Castellano raised nearly $1.5 million from 18 investors by promising 6-8 percent returns on the investments. However, instead of investing the funds, Castellano paid off his own expenses and made fake “interest” payments to some of the previous investors.

These recent enforcement actions are examples of the type of disclosures to the SEC about securities fraud or ponzi schemes that can qualify for a SEC whistleblower award.

SEC Whistleblower Program

Under the SEC Whistleblower Program, whistleblowers may receive a reward for providing the SEC with original information about securities fraud. If the SEC uses the whistleblower’s information to bring a successful enforcement action, the whistleblower is eligible to receive 10% and 30% of the monetary sanctions collected as an award. Since the enactment of the SEC Whistleblower Program, the agency has paid more than $150 million in awards to whistleblowers.

According to a recent speech by SEC Enforcement Director Andrew Ceresney, fraudulent securities offerings and Ponzi schemes are the types of cases where whistleblower assistance is especially valued. The Director noted that whistleblowers have helped the SEC identify false and misleading statements in offering memoranda and marketing materials, which enables the agency to act quickly and prevent investment frauds from luring more investors.

Offering Fraud

Offering fraud involves a security’s being offered to the public on terms that are materially misrepresented. For example, guaranteeing a return on an investment and offering “risk-free” investments are considered material misrepresentations. This type of fraud continues to be a focus of SEC enforcement. According to the SEC Whistleblower Office’s 2016 Annual Report to Congress, offering fraud was the second-most-common complaint reported by whistleblowers (15%), the most common being corporate disclosures and financials (22%). Tips about market manipulation were not far behind (11%).

SEC Enforcement Actions

In a recent offering-fraud enforcement action, UBS agreed to pay $19.5 million to settle charges that it misled U.S. investors about its structured-notes trading strategy. According the SEC’s press release, UBS falsely stated that the investment relied on a “transparent” and “systematic” currency-trading system that used “market prices” to calculate the financial instruments underlying the index. In reality, UBS failed to disclose hedging trades that reduced the index price by about 5%. As a result of the reduced index price, investors lost roughly $5.5 million.

In another offering-fraud action, the SEC charged California’s largest agricultural water district with misleading investors about its financial condition as it issued a $77 million bond offering. The water district represented to investors that it met or exceeded a 1.25 debt service coverage ratio, which it was required to maintain pursuant to a previous bond offering. In order to meet this ratio, the water district used misleading accounting to record additional revenue by reclassifying funds from reserve accounts. The general manager of the water district jokingly referred to these transactions as “a little Enron accounting.” The actual coverage ratio was only .11, instead of the 1.25 reported to investors.

Ponzi Schemes

The SEC defines a Ponzi scheme as “an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.” The fraudsters are able to keep the scheme running only by attracting new money to make promised payments to earlier-stage investors, thereby creating the false appearance that investors are profiting from a legitimate business. The schemes tend to collapse when the fraudsters are unable to recruit new investors or when a large number of investors ask to cash out.

Warning Signs of a Ponzi Scheme

The SEC compiled a list of red flags that are common to most Ponzi schemes. These warning signs include:

high investment returns with little or no risk;
overly consistent returns;
unregistered investments;
unlicensed sellers;
secretive and/or complex strategies;
issues with paperwork; and
difficulty receiving payments.

SEC Enforcement Actions to Combat Ponzi Schemes

In a recent enforcement action, the SEC charged an investment group and three top executives with hiding the rapidly deteriorating financial condition of the enterprise while raising more than $350 million from investors. In the scheme, the executives defrauded more than 1,500 investors into believing that they were investing in healthcare, education, and transportation, when their money was really being used to keep the firm from going bankrupt. It was considered a Ponzi scheme because some of the money from new investors was used to pay earlier investors.

The operation showed some of the typical warning signs of a Ponzi scheme, such as promising high rates of return that ranged from 8.5% to 10%. In late 2015, the scheme unraveled after the firm could no longer meet scheduled redemptions.

In another enforcement action, the SEC charged a real estate company with engaging in a $2.7 million Ponzi scheme that targeted elderly investors. Like many Ponzi schemes, the company “guaranteed income” to investors. This income was purportedly derived from the profits of a Pennsylvania real estate venture that bought, redeveloped, and sold properties. In reality, the company did not operate a real estate venture, and it used the investments for personal expenses, such as purchasing tickets for sporting events, paying college tuition, and maintaining personal credit cards.