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RELATIONSHIP MATTERS: UPDATE ON TIPPER – TIPPEE LIABILITY; JOSEPH BARTHOLOMEW ALLEGED PONZI SCHEME; AND SEC’S NEW FIDUCIARY RULE

By Dennis A. Stubblefield of Shustak Reynolds & Partners, P.C. 

"It's All About the Rel', 'bout the Rel', No Problem…" is a Meghan Trainor-inspired musical way to think about two big developments in the last week: the very big and very new news out of the Second Circuit on Insider Trading, and the very sad, but very old-story, news out of Lake Forest, California on the latest high-profile Ponzi Scheme.

On December 10, a unanimous Second Circuit panel not only reversed two high-profile Southern District convictions of remote tippees, but dismissed the indictments as well, thus effectively preventing any further prosecutorial moves by way of re-trial etc. See Tom Gorman's blog for details, but the bottom line now on tippee liability is that it's all about the relationship between tipper and tippee.  Tippee liability is entirely derivative. The Court went back to Dirks' personal benefit test: as mere disclosure of inside information is not per se illegal, "without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach [by the tipper/insider]." And the Court puts meat on the bone of "benefit:" no more loosy-goosy notions of the long-term hopes of feel-good social or casual interactions. There must be proof of a "meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature…in other words one that suggests a quid pro quo…"  That is, something given by the tippee to the tipper in exchange for the disclosure, or, alternatively, a clear intention by the tipper to benefit the tippee.

In the world of major frauds, the Orange County District Attorney just brought criminal charges arising out of a nearly decade-long insurance-based scheme. The alleged fraudster, Joseph Bartholomew, is accused of running a Ponzi Scheme selling unregistered securities based on (largely or wholly) fictitious third-party insurance policies. According to a recent article in the Orange County Register, "…Nancy Kincaid, spokeswoman for the state Department of Insurance called Bartholomew, at the time [presumably the period July 2005 through May 2014] a licensed insurance agent, the "Bernie Madoff of Orange County…[he] used his insurance business to gain people's trust." According to an article by writers under the banner of a local NBC affiliate, Bartholomew promised "…15 to 20% annually in returns."  The OC Register reported that a church was somehow involved, as was a former Angels baseball player [Bobby Rose, according to the NBC-affiliated article, who apparently lost $2.9 million]. Undoubtedly, what happened was this: Bartholomew leveraged the authority and legitimacy implicit in his insurance business and his good-citizen status with the Church, got a few early clients and parishioners on board, and then sat back and churned, burned and cooked books over the next ten years as more and more people heard about this great thing.

It's the oldest game in the book: affinity fraud. It's based upon seemingly close relationships amongst those with something or someone significant in common, particularly those groups that have the widely-shared attribute of being safe and sound, like churches.

Although, Congress in 1933 and 1934 replaced caveat emptor with caveat seller as an overarching legislative philosophy underpinning the federal securities laws, the remedies available to securities fraud victims are usually only as good as the presence of deep-pocketed, viable defendants. So good luck to these Orange County victims: they will need it. As for whether the persons who just won on appeal in New York ever caused any real harm to any real investors or traders, well, let's just say that that is a hotly-debated topic about which there is much to read.

And just another reminder that investors cannot count on the securities or insurance regulators/enforcers to get them their money back. As a practical and very important matter, caveat emptor really should still be the watchword for investors. Beware of billionaire brats bearing ba ba boom plays, beware of new best friends suddenly seeming like chums. Beware of the oh-so-sweet sounding soothing pitches via the sales and marketing channels, like the spot I heard a few months back on talk radio hawking private placements in senior facilities, with one of the investors gushing that (paraphrased), "it feels so neat to be able to be in this cool investment with some of my closest friends." No amount of written disclosure driven by legal and compliance can prevent the inexorable march toward closing for an investor who truly believes that the person who she's dealing with is a "good guy," or those who, sadly, perhaps are thinking of their affiliation with the investment and their adviser, in the same way that many retired investors over the years hang out at their stockbrokers' offices and watch the tape go by.

So, back to music for a moment, "It's All About the Rel', 'bout the Rel' (big problem?)." I use music here to hopefully make this memorable, like Brad Bennett did at Finra Annual In 2012. Bennett, head of Finra Enforcement,was on a panel covering Enforcement issues, and a question came up about how broker-dealers can take their gripes "up the line" if a line Examiner or Investigator is being unresponsive or unreasonable. In telling the audience that it was always OK to go up the line, he said, "Call me (or, perhaps, like Carly Rae Jepson says, "Call Me Maybe!)" Down the line I will weigh in with what I believe he meant by this, but, for that panel, and the people who knew this pop smash at the time, all that was important was the punch, the humor, and the memory. Isn't this the heart of what investors take away and retain from their very first encounter with the person sitting across a solid-looking desk inside a decent office building, or next to them at church? So often it sounds safe and sound.

Capital Cities' "Safe and Sound," was a huge pop hit in 2013. And this phrase might describe the best intentions of the Dodd-Frank authors. But, as Matt Levine, Paul Atkins and others point out, no amount of law or regulation can really do that much effectively about eliminating risk, and many argue that market and investment risks are much worse today than in early 2009. And for the stuff that really matters, or should matter, to legions of retail investors and/or the victims of Bartholomew's fraud, the SEC still hasn't come out with its new fiduciary standard nor completed its guidance on just how issuers, broker-dealers and others must verify accredited investor status when availing themselves of the general solicitation permitted by Rule 506(c).

Going forward, Finra will be guided by the SEC's Fiduciary rule. But for some time now, a key focus of Finra has been the message loud and clear to its broker-dealers: identify, manage and eliminate to the greatest extent conflicts of interest across the board, especially between firms and their customers. And, even grafting a robust fiduciary standard on BDs and their reps will not be anything close to a panacea: even RIAs, who so loudly proclaim their independence and diss the Series 7s of the world, even these fiduciaries do not have identical interests with any of their clients.

As we have written previously, we hope that SEC takes a good hard look at priorities, and doesn't lose sight of purely locally-based major frauds such as what apparently just happened in South Orange County; perhaps, for Insider Trading, it will take guidance from Newman and get back to the basics of Cady Roberts

But for investors, look only to yourself for ultimate guidance and accountability, and don't count on getting any money back when things go south. That contact of yours who sold you the securities—whether you call him a "friend" or not, and whatever the true relationship may have been—that person may not be so friendly…and any firm he is with may not be much friendlier… Ask the tough, and the easy, questions—like, "is this too good to be true?"— on the front end, not the back side.

Ryan Baesemann