June 2015 n Volume 19 n Issue 6 Wall Street Lawyer on%20Cybersecurity%20Practices_0.pdf (here- lated matters a regulatory and enforcement prior- inafter “FINRA Report”). ity over the past several years.1 They have brought 36. See, e.g., FINRA Report at Appendix II; see also Cybersecurity Risk Management and Best claims against and fined many individuals and Practices Working Group 4: Final Report, (Mar. entities for engaging in many different types of il- 2015), available at http://transition.fcc.gov/ legal penny stock activity.2 These include pump- pshs/advisory/csric4/CSRIC_WG4_Report_Final_ and-dump schemes; manipulative trading tactics; March_18_2015.pdf. 37. Cybersecurity Guidance at 2. the sale of unregistered securities; boiler room op- 38. NIST Framework at 14. erations;3 excessive, undisclosed, markups on pen- 39. NIST Framework at 14. ny stock sales; failure to have and implement an 40. NIST Framework at 14. 41. See Cybersecurity Guidance at 2, nn. 7-11. adequate anti-money laundering compliance pro- 42. See generally supra nn. xxi-xxii. gram; violation of the Bank Secrecy Act; failure to 43. NIST Framework at 24-25. enforce supervisory controls and procedures; and 44. Executive Order 13691—Promoting Private Sec- failure to have and implement adequate supervi- tor Cybersecurity Information Sharing, 80 FR 9347 (Feb. 20, 2015), available at http://www. sory procedures to, for example, detect and report gpo.gov/fdsys/pkg/FR-2015-02-20/pdf/2015- suspicious activity and determine when securities 03714.pdf. are part of an illegal unregistered distribution.4 45. See supra n. xviii. Sanctions for these activities have included barring individuals and firms from the securities industry, barring them from associating with a broker-deal- er and/or participating in a penny stock offering, The Treacherous disgorgement ranging between $4,745 and $9.6 million before pre-judgment interest, which was Terrain of Penny often applied, and civil penalties ranging between $20,000 and $3.3 million. FINRA has fined firms Stocks and How up to $8 million. Both the SEC and FINRA have provided guid- Firms are Attempting ance to firms as to what they should be doing to guard against some of these issues in their own to Navigate It businesses. Generally, they recommend that firms review their policies and procedures related to BY ELYSE K. YANG, JOHN WORDEN, JACK DROGIN & PATRICK VEASY these matters to be sure they are conducting ad- equate due diligence on their customers, their Elyse Yang is an Associate in Schiff Hardin LLP’s Financial customers’ accounts, and customers’ claims that Markets and Products Group. Ms. Yang represents and particular securities are exempt from registration. counsels broker-dealers, investment advisors, individuals associated with those businesses, and self-regulatory or- ganizations in regulatory, compliance, and litigation, mat- ters. She works out of the firm’s Chicago office. John Wor- SEC Actions: Complex Fraud and den is a trial lawyer, including financial services disputes, Focus on Gatekeepers and is a Partner in the San Francisco office. Jack Drogin is a Partner in the firm’s Washington, D.C. office and fo- The SEC established a Microcap Fraud Task cuses his practice on SEC and self-regulatory organization Force in 2013 and is specifically targeting persons rules and requirements relating to the federal securities they have identified as “gatekeepers”—broker- laws, broker-dealers, markets and clearing agencies. Pat- rick Veasy is an Associate in the San Francisco office. dealers, transfer agents, attorneys, auditors, stock promoters, and shell company purveyors, among The Securities and Exchange Commission others. 5The activities they have uncovered have (SEC) and Financial Industry Regulatory Author- frequently involved a combination of the illicit ity (FINRA) have made penny stock fraud and re- activities discussed below. 8 © 2015 THOMSON REUTERS Wall Street Lawyer June 2015 n Volume 19 n Issue 6 Pump-and-dump • Engineering of reverse mergers by individual to obtain shares of companies’ stock to then The SEC has acted against individuals and enti- ties involved in pump-and-dump schemes, which drive up the price of the stock through the vary widely in complexity and scope.6 For ex- dissemination of false and misleading state- ample, the SEC has prosecuted schemes involving ments and selling the stock for large prof- 14 the following activities: its —That individual was ultimately ordered to pay disgorgement plus pre-judgment inter- • Promotion of penny stocks on clients’ or oth- est totaling $921,232.15 ers’ behalf, through the publication of state- ments that contained material misrepresenta- • Facilitating a pump-and-dump scheme by tions or omissions, to increase the price per selling shares of a particular penny stock on share of the stock7—In these cases the SEC multiple customers’ behalf—The SEC has brought claims against both the individual(s) brought action against a stockbroker it al- promoting the stocks, the stock promotion leged did this and in doing so the stockbroker company, if applicable, and officers of the was said to have ignored red flags and failed company whose stock was being promoted, to make a reasonable inquiry to determine if they were involved in promoting the stock.8 that his customers were not acting as under- The individuals the SEC pursued in these writers.16 This stockbroker settled the Com- matters were required to disgorge their ill- mission’s claims against him and, pursuant gotten gains ranging between $91,000 and to the settlement agreement, paid $313,257 $605,262 plus pre-judgment interest, and total in civil penalties, disgorgement and pre- civil penalties ranging between $50,000 and judgment interest.17 $191,000.9 A stock promotion company was ordered to disgorge $605,262 plus pre-judg- • Scalping penny stocks18—Scalping, which is ment interest and a $1 million civil penalty.10 similar to pump-and-dump, involves some- one recommending the purchase of a stock • Manipulation by owners of penny stocks while being poised to sell the same stock into and/or executives or directors of the com- the market immediately after disseminating panies whose stock was manipulated to ar- the recommendation. The individual scalper tificially increase demand for the stock by was required to disgorge $1.9 million plus issuing false press releases, facsimile and pre-judgment interest and pay a $1.7 million email spam campaigns, promotional videos, civil penalty.19 websites, and/or automatic voicemail mes- sages and, often, selling their shares once the price increased11—The Commission pursued Manipulative Trading individuals, as well as the companies whose The Commission has sued those individuals stock was being promoted. The individuals who, in an effort to drum-up trading activity in a promoting the relevant penny stock were particular stock, engaged in manipulative trading ordered to disgorge ill-gotten gains ranging of penny stocks. The manipulative trading tactics between $40,600 and $7.2 million, plus pre- and schemes employed in those cases have includ- judgment interest, and civil penalties between ed the following: $50,000 and $1.3 million.12 The Commission sued a stockbroker for his role in a scheme • Executing matched orders20—The individu- that employed this type of activity. He was als who attempted to manipulate the market ordered to disgorge his illicit gains and pay a by executing matched orders ultimately were civil penalty. He was also enjoined from en- each enjoined from future violations of the gaging in any future offerings involving pen- Securities Act and/or Exchange Act and were ny stocks and barred from associating with barred from being involved with any penny any broker or dealer.13 stock offering. © 2015 THOMSON REUTERS 9 June 2015 n Volume 19 n Issue 6 Wall Street Lawyer • Purchasing shares of the stock to raise its • Purchasing unregistered shares of penny price21—The individual who purchased stocks and selling them to the public without shares of the penny stock to drive up demand registration statements31—Some individuals for and thus the price of the stock was re- engaged in this scheme were required to pay quired to pay a $120,000 civil penalty.22 disgorgement in amounts ranging between $4,745and $5.9 million and civil penalties up • Executing wash sales in a particular penny to $3.3 million.32 The SEC also brought an stock23—The individual, a former stockbro- action against two firms for facilitating the ker who executed wash sales in penny stock sale of unregistered securities by its custom- he owned was not required to pay disgorge- ers. The firms were jointly and severally liable ment or a civil penalty based on his sworn for disgorging $1.5 million and for paying a statement regarding his financial condition.24 $1 million civil penalty.33 (Note: Individuals who employed multiple use of these manipulative trading tactics suf- • Obtaining penny stocks and re-selling them, fered the same consequences but were re- unregistered, to the public under Rule 504 quired to disgorge a total of $552,579 plus of Reg D but exceeding the $1 million limit pre-judgment interest.25) of unregistered securities a company can sell under that exemption34—The SEC sued indi- • The SEC worked with the Federal Bureau of viduals and entities involved in this activity. Investigation to uncover schemes in which The individuals were required to disgorge individuals offered kickbacks to hedge fund between $12,500 and $6.2 million plus pre- managers or pension fund managers