Understanding Securities Litigation and Enforcement

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As the COVID-19 pandemic has created economic uncertainty and volatility in the market, there may be increased securities-related claims from investors both under federal and state law, as well as enforcement actions from the regulators. This webinar will discuss key issues that may arise in these types of litigations.

Topics include:

  1. Rule 10b-5 claims
  2. State securities claims under the blue sky laws
  3. Defenses
  4. SEC and/or state inquiries.

Darlene Hernandez:

Welcome to the webinar, understanding Securities Litigation and Enforcement Webinar. Thank you all for joining us. This is Darlene Hernandez, along with Tae Kim from the Geraci Corporate and Securities team. For those of you just joining us for the first time, we welcome you.

Tae Kim:

All right, thank you so much for that Darlene, and thank you so much for joining us today. As Darlene noted here, we're going to be talking about the Understanding Securities Litigation Enforcement. This is part of our new normal educational series that we wanted to continually inform our investors and our clients regarding some of the issues that have been commonly been arising due to some of the Covid issues as well as on a general fund management perspective. Again, my name is Tae Kim and I am with Darlene Hernandez, and we're definitely going to be having a great time here together discussing about these enforcement actions.

Okay, cool. Before I introduce myself just a couple of housekeeping matters. Please put your questions in the q and a box. As you may notice here, there may be a q and a and there's also a chat button. Please put your questions at the q and a box and we will answer them at the end of this webinar. And also just want to let you know that this is being recorded. We'll deliver this webinar recording with the slides after the presentation is over. Having said that, again, my name is Tae Kim. Hello corporate and securities associate attorney here at Geraci Law Firm. Work closely here with the partner Kevin Kim, and another associate of ours, Olivia Darnell. We advise fund managers and fund sponsors through the securities compliance issues. We form a funds when it comes down to debt funds or mortgage funds any other real estate related type of funds, including qualified opportunity funds and other syndications. We also assist our clients through our reformation. Darlene, do you want to introduce yourself?

Darlene Hernandez:

Thank you, Tae. I work together with Anthony Geraci and Marisol Nagata, who you may have seen at previous seminars. We handle the litigation and bankruptcy issues relating to the clients at Geraci.

Tae Kim:

Wonderful. Thank you so much. So we're going to be talking, as I stated before about this shareholder litigation and SEC and state enforcement actions that we have been seeing. So we decided to break this down in two parts. Okay. First part, we're going to be talking about the shareholder or member litigation, basically investor litigation. What are some of the common actions that arise both at the common law level and at the securities law level, and investor remedies that are available, corporate governance and matters, and indemnification, and other defenses that are available to the fund sponsors. This is a very interesting topic and there's a lot of legal aspects of it, and we're definitely going to be diving a little bit deep into these topics. But as any law stuff, this is pretty sometimes very convoluted and it can get pretty boring. And so I want to just throw this out there to all of our clients and the attendees.

Just main takeaways here, just so that we can boil this down and simplify it at what does this mean for me as a fund sponsor or fund manager? What am I supposed to be doing? So here are the bullet points. Okay. Main takeaways. Number one, really act in the best interest of the investors. Okay. Number two, treat investors fairly and equally when it comes down to redemptions, distributions, when it comes down to disclosure of reporting whether it's through financial reporting that you guys typically do or any other types of offering documents for disclosure purposes, these are all supposed to be treated on an equally and fair basis to all investors. Disclosed material facts. I mean, those are all in there as part of the baseline, which will be the ppm, the private placement memorandum or offering circular if you're in Reg A as well as any other updates or any other types of financials that you guys report to these investors.

These disclosure of material facts is important and pretty common sense stuff. And when it comes down to fund management, some of the things that I have seen that some of the fund managers do not really do this, and it's actually surprising is record keeping, accounting, and safety of funds. Be sure to keep a record as well as accounting of where the funds are going and how things are being deployed, what the distributions are being paid typically in the form of an accounting, whether it's through an Excel spreadsheet or through a software, or if you're using a third party fund administrator. That is probably an important aspect that is important to do. And the fifth takeaway that we want to do, we want you to take away from this webinar is investor communications. And it's not just investor communications per se. Yes, investors are in a sense partners with you as a fund manager, right?

But there's got to be a certain limit when it comes down to, and we want to trust and we want to develop that relationship. But when it comes down to investor communications, organization of that investor communications, storage of these investor communications, and making sure that these are written in a way where it actually can benefit you later on down the road in the event that the relationship goes south. And Darlene is going to be talking a little bit more about that later on down the road, some of the experiences that she has because at the litigation level, it's actually backward looking, right? In the sense that all of us for the corporate level at the fund formation level, it's always forward looking. We're always forming the fund with the anticipations and the issue spots as to what may happen, but litigation you're looking at from the backside as to what did happen and what is it that is most beneficial to the fund sponsors from a litigation perspective, especially when it comes down to investor communications.

And so yes, the first three is pretty common sense. It's pretty straightforward. Act in the best interests, treat investors fairly and equally in disclosed facts. But when it comes down to the fourth and fifth level, having these record keeping and investor communications at the organization level seems to be very helpful at the litigation level. So as I stated here before, if you fall asleep during the webinar, remember these points. Okay. All right. So moving on Darlene, tell us a little bit about some of the common law causes of action that occur in the shareholder litigation.

Darlene Hernandez:

Oh, absolutely, Tae. Tae makes a very good point. If you could remember those main points, you can avoid litigation, not completely, but if you can it's best to do so. But when you do get to the point where you have a disgruntled investor and they decide to file a complaint against you here are some of the claims that typically arise under common law claims by the shareholders or members. One is fraud. And that is probably one of the most common claims that relate to a breakdown in communications, a misunderstanding, a misstatement, a flat out lie. So these representations are actionable. And so it's very important to make sure that any statements that are made are true and accurate. Another claim is breach of contract. If there are promises being made within the offering documents, you want to make sure that you deliver and perform under the contract or the shareholder member will file a claim for breach of contract and you would be exposed to damages relating to that breach.

The third type of claim that falls a little bit below fraud but is just as common is negligence. So that's where a statement that was made that could be misleading, but there was no intent for it to be misleading. So it falls just short of fraud. And so when a manager has a duty to you as the investor or the shareholder and they breach that duty of care, the standard of care for the industry, then that exposes you to potential damages under a negligence claim. The next type of common law cause of action is breach of fiduciary duty. And that usually falls within the umbrella of fraud and negligence. And so the duty under the duty of care, under the breach of fiduciary duty, what is the standard of care for a fund manager for the shareholders or members? And then second, what is the duty of loyalty? What is the duty of loyalty? So loyalty involves whether or not a shareholder, whether a fund manager puts their interest ahead of their shareholder's interests, and that becomes either a direct or potential conflict. And one of the things that occur with respect to the conflicts of interest is when there's no or not complete disclosures made to the investors. And that brings us down to investor communications. Were the disclosures made or was there a partial disclosure of information that was material to the investor's decision in putting their trust in your hands?

Another aspect of fraud is theft or misappropriation of funds and that is something that it falls within the edge of civil and criminal penalties. And later on we'll talk about actions by the regulators such as the securities in Exchange Commission. But I just wanted to touch upon these common law causes of action in the beginning to give you a flavor of what types of claims are available.

Tae Kim:

Perfect. Sounds good. And so yeah, just like what Darlene has mentioned, those are some of the common law causes of action that the shareholders or members in fact pursue in the event that there's a breakdown in the relationship between the fund sponsor and the investor. So well, what about the defenses? What are some of the defenses that are available to the fund sponsor or the fund manager? And so in the private investment arena especially in the debts funds, and as well as other private investments, there is a certain standards where the s e C as well as the courts that recognize when it comes on to the governance level. So there's a standard of duty of care, as Darlene just mentioned, right? Acting in the best interest of investors when you have a potential or an actual conflict of interest disclose to the investors. And those are typically done in the offering documents.

So what happens when you fall below that and how far do you actually have to fall below that standard of care such that you're actually going to be incurring liability? And in the offering document, especially in the operating agreement, it should state that you know are protected from that. There is a standard of care, but yet if you do fall such that there is a gross negligence, fraud, bad faith, willful misconduct, or any other violation of law basically doing bad things, then you're liable. But if you haven't, then you're protected under two different things. Number one is indemnification it. Check your offering documents, especially in the operating agreement, whether you do in fact have that indemnification clause in there because indemnification is basically a compensation for harm or loss or you're actually being from liability from any damages that in fact the investor is actually pursuing.

So investor is going to claim you did fraud, you did bad pay, you did all kinds of other bad things, and then the fund sponsor said, no, I didn't. And here's the reasons why. And you defend against any of these types of claims. Well, you're going to have to spend money, you have to spend money on the legal fees, you have to spend money on depositions and all the other ancillary damages and other expenses and fees and costs that comes along with litigation. Well, if you haven't done it, then you should be indemnified from it and be exempt from the harm or loss comes along from it. And that's where the operating agreement will state or it should state that you are actually can recoup or reimburse or even advance some of these costs that comes about depending on the scope and depending on the scope of the operating agreement provision.

The second one that is actually protecting the fund sponsor is called the business judgment rule. And this basically said, if you have acted on the best interest of the investors and you have done it as if a reasonable corporate director or a manager would have done at within a reasonable person who should have acted at the time when they have acted on that, then you are protected under this business judgment rule. It is a common law, meaning that the state in fact, actually has installed these rules through the courts based upon the common law that they have developed over the years. California definitely has it. It's called California Corporation Code. It's section 3 0 9 if you guys want to take a look at that. Delaware also have it. And generally almost all states should have this corporate governance protection and that is available to the fund sponsor. And so those are two of the things that do protect the fund sponsors. And so Darlene so say that the investors are in fact successful in their lawsuit. What are some of the remedies that are available to them when it comes down to the investors remedies?

Darlene Hernandez:

Well, Tae, the first thing that investors want to do at the very least is get their money back. And that's where redemption comes in. And if they can get anything besides damages or if there is a claim for fraud or negligence for fraud, there's punitive damages, which can be anywhere from three to 10 times the amount, depending on what a jury would find if there was a finding of either gross negligence or fraud. Another remedy is rescission. What is rescission? Rescission is a cancellation of the agreement and the parties are obligated to bring each other back to where they were as if there were no contracts. So if there was an exchange of money, that exchange of money will be returned. Our attorney's fees allowable in any of these claims. It depends, and depending on what the offering agreement states or any other contractual agreement, there should be, or we recommend that there be an attorney's fees provision so that when an investor needs to file a lawsuit that they can at least recover their fees and costs incurred for having to file the lawsuit going down to damages. Again, damages you can get compensatory damages, which is the amount that is the value of the contract or the agreement damages relating to either fraud or negligence, could be punitive damages or damages that arose from lost profits. So restitution also is a fancy word for recovering monies that should have been recovered as a result of your investment. And if that includes lost profit that will also be a possible claim for investor remedies.

Tae Kim:

Perfect. Yeah, so as Darlene mentioned, these are some of the remedies that are available to the investors in the event of the event that he or she prevailed from lawsuit. But most from a practical purposes or that I have found out from a personal experience is that most investors, they don't want to go through the trouble of lawsuit, right? I mean, you got to hire an attorney, you got to actually spend the legal fees and you got to actually go and file suit and do all kinds of other jump through various hoops to arrive at filing a complaint. At the end of the day, they really just want their money back. If they're not happy about it, whether it's a performance or whether they just simply want to get out of the fund, then you know, just get their money back. And typically that's some of the fastest, in the most simplified way to basically cover yourself from any types of remedies or any types of lawsuit as that's some of the things that I have found out that is in fact actually very beneficial to both the fund sponsor and the investors when it comes down to just basically giving their money back.

And what's so good about what I really believe in our industry is that these are debt funds. Most of our clients are debt funds. And basically you take the investors' money and you deploy the funds for purposes of loans, and those are secured by real estate. And most of our clients, if not all of our clients, have a very low LTB ratio such that there's enough cushion in the events that there is, that the economy goes south and that the real estate values in fact goes, is so substantially low yet that there will still be enough to cover any of the investor's money. So in the event of any foreclosure or REOs, you know, actually will get recoup that money back and the investor's money will in fact from practically speaking to be safe from that.

But have you said that from a legal perspective, we always indicate to our clients the risks that are associated with being in private investments outside of fraud. Most of our clients, all of our clients do in fact deploy this money for purposes of making loans. And so it's not at a hedge fund, you're not trading securities, you're not investing in companies in a VC or any type of private equity arena where there's a substantial ups and downs when it comes down to the risks that are associated on deploying the money. And so that's why I really believe in our industry when it comes down to investor protection as well because from a business or practical purposes, these seems to be really efficient and a very beneficial way for the investors while getting their fixed income income coming from the interest payments. So having said out, we're going to turn our webinar here a little bit and we're going to talk about s E c treatment and involvement.

Some of the things that we have been seeing from a federal side as well as state actions just really wanted to give a little bit of a blanket thought process here. Just because we live in private investment, reg D 5 0 6, rule 5 0 6 funds doesn't mean that the state doesn't have any say. I think that's a common misconception that I continually hear states do have a say when it comes down to these types of funds. Okay, what does preemption really mean Is that you know, are selling and you're offering securities to the investors under the exemption and that you don't have to actually register as an investment fund within both at the federal and at the state level. That's what the rule 5 0 6 gives you is still does not absolve some of the actuals that actually are available from a state level. And we'll talk about that as we continue on here.

So just a general common cause of action from a securities perspective rule 10 B five action. It's really at the end of the day fraud. Okay, was there any misrepresentation of facts or a mission of facts that have misled the investors? Did the investor, did you actually have the knowledge of this misrepresentation or mission of material facts, the time when you have actually made this representation or lack thereof, and did you actually lose investors money? That's just the three common elements. I mean it gets more, much more granular detail, but these are just basically the layman just a common way of just looking at rule ten five action. And so these are available both at the federal state, and actually investor actually can use this as a cause of action when they are suing the fund sponsors. Darlene, do you have any thought process or any experience that you may have had come across when it comes down to the Rule 10 B five action, perhaps a personal experience that you have gone through from a litigation case that you have seen?

Darlene Hernandez:

Yes Tae but just recently in July of 2020 a prominent San Diego businesswoman by the name of Gina Champion Kane had pled guilty to securities fraud conspiracy and obstruction of justice. And what happened was she defra defrauded investors out of 400 million through a liquor license lending Pro program. What she did was she misled investors into believing that they had an opportunity to fund high interest short term loans to people seeking California liquor licenses. And what she did was she fabricated documents to to get the investors to put money into her fund and instead she used the client's money, the investor's money to support a lavish lifestyle and also to fund her other businesses. So she was the SEC filed a complaint against her in August of 2019 alleging violations of Rule 10 B five for misrepresentation and for damages in scamming not only in individual investors, but also banks and investment funds.

Tae Kim:

Cool. Well thank you so much for that. And so just continuing on here, when it comes down to the enforcement actions and so this is really not an enforcement enforcement as you could kind of see, but to really more of at the compliance level in our private investment arena, there is a form filing that we ubiquitously file the state notice and the federal notice when it comes down to the the compliance level do that at yearly at minimum, or any times when there is a material change to the corporate organization or other aspect that would warrant to the form de filing, including any increase of any maximal offering amount. And from a personal experience, what I found out at the state level these are pretty intense sometimes especially when you haven't not filed this on for period of time, say two or three years. And so state levels range widely, okay, they have a wide range of fees.

When it comes down to the filing fees, it's between about $550 to about $750 depending on the state where you're filing. Remember that the state filing for the Form D notices is supposed to be where the investor resides. So if you have any issues right now when it comes down to the state notice filings, please let us know. We'll definitely walk you through this when it comes down to the filings. Another thing that I found out is that if you do not do it for a period of time, some states do in fact knock on your doors. They do in fact try to threaten ways to state that you are actually in violation of the failure to file the state form D notices. And so we are even issuing what we call a consent order.

It's pretty scary honestly, and I think it's sometimes overblown, but at the end of the day, states or states, they have the right to do this. And so I guess my point is at the end of the day, please fire state notices. Those are probably more, I don't want to say more important, but it is just as important on the federal level, federal level, you just file the forms you notice and you're fine. But at the state level, they seems to be very granular and there is a little bit more say in what they do. And so that's some of the things that I've definitely wanted to note here. Second part here is improper or non-disclosure of your business practices, including fees. What are the fees that you're talking about? And in our world, we talk about origination fees, processing fees loan extension and modification fees, servicing fees.

When we note about all these types of fees but sometimes we charge things that is actually not properly or improperly disclosed that we will charge these fees as opposed to we may charge these fees. Some of those wordings in the languages SCC picks up on these fees are very sensitive when it comes down to the the offering docs. And so be sure to take another look at your offering document to make sure that the proper fees are disclosed. And if it hasn't been, then do it. And that's some of the things that we have to make sure that it's remedied on a prompt basis for disclosure purposes. And the thirdly that I just talked about, non-compliance with blue sky laws or the state laws, for example, finders fees. S SCC does have a specific finder's fee provision where it's basically not transaction based fees and other ancillary and other types of activities that the person must have besides actually taking into these type of finder fees.

But on other states such as, and I'm just naming three out the top of my head, Maryland, Ohio, and Washington, they do not recognize any third party non-registered finders. And so if there are any investors within those states, and there is a finder speed that is in connection with that that is in non-compliance with the blue sky law with those states. And so I always tell my clients, just don't take finder's fee as a general rule because you know why mean these are supposed to be a registered investment advisor or broker dealer when it comes down to it. And if it gets very tricky. And so why walk into that type of line? I understand that you didn't want to raise capital, but at the same time, understand that states do come into play when it comes down to these compliance issues from a securities law.

And last but not least, when it comes down to the enforcement actions, bad actor, this is the ultimate bad thing. So what does bad actor mean? So bad actor really is when that person, either the fund sponsor or the principal of the fund managers or the fund in of itself has either been convicted in crime, there has been a court injunctions or restraining orders, there has been other types of a final order from a certain state or federal regulator that has to do with fraud consent order or cease desist order. The big things, these are actual enforcement where you know, SCC or the state regulators in fact hands you down these types of orders, that and of itself can trigger bad action. A bad actor provision such that you actually are disqualified from raising capital for up to 10 years. And that's kind of scary from a fund management perspective.

And so being careful and making sure that you do comply with the duty of disclosure, the duty of loyalty, the duty of care that Darlene and I just mentioned from a takeaway from a simplistic pur purposes can go a very long way. And so these are definitely available at the s e C level and it's something that you have to think about when we're in the securities business. At the end of the day, security flaw is it's a pretty scary business to be in. They're taking someone's money and who knows what. We can do it because at the end of the day, all we have left is that contract, the offering documents. And from an investor's perspective perspective, the SCC and the state regulators want to protect them in all way possible, especially in the public financing arena. But in the private investment, we are dealing with a credit investors and the ideas that they can actually fend for themselves.

But at the same time when we're talking about these, the big F word, the fraud or any misrepresentation, these are some of the consequences that I wanted to convey to our fund managers from an enforcement purposes. So now that we have gone through some of the aspects on the shareholder litigation, SCC and the state regular purposes, now what's next? These are some of the best practices that we've mentioned in the beginning, but I wanted to reiterate here. And so some of the things that we wanted to actually say, right? Transparency disclosure act in the best interest of investors being a fiduciary. And if there is a investor relations that's actually turning sour, then well, what's the plan of action? What do you guys want to do? Is it, you know, guys want to go through the lawsuit and preferably not right, because you don't want to spend the legal fees on top of it with the potential that there may be liability or is it just a redemption and a release and off you go. That's probably the easiest way to go about. But having that plan of action is important from an investor communication purposes. But Darlene, do you want to add anything in here when it comes down to best practices?

Darlene Hernandez:

Let's talk about the plan of action and redemption because there was an issue that had come up on the litigation side where we had a client come in and he basically wanted redemption. He was an investor. And when we had made a formal demand to the sponsor, the sponsor didn't respond. So what was that? Investor's remedies, how do we get them to answer? And so we contacted the regulatory agencies, the S E c we also contacted the sponsor and made demand on them to either return the money or give an explanation for why are you not returning the money? Or also providing supporting documents for their lack of communication as well as disclosure. So that's something that may come up for our clients. And just wanted to give you the flip side of what happens when you can't get redemption.

Tae Kim:

Okay, some of the other best practices here check your offering documents. If we talked about indemnification clause, be sure that that's in there. See if your offering document does in fact reflect your current presence practices, it's always good to at least annually or quarterly check these offering documents. We recommend at least annually review your loan portfolio to see if what it is, what you have right now is in fact current and in reflection with and inconsistency with the offering documents make sure that you know are doing the record keeping storage and organization of investor communications in the event of any potential lawsuit. And some of these best practices here can go a long way because let's say that litigation does ensue, then you got to go and back and literally go through millions of emails that you have within your storage. Or there may be other record keeping that you are not aware of, but these are some of the things that can, if you go up at the front end and you kind of store where it needs to be, then you're good. And so it's actually organize and you can actually defend in a much more efficient manner. Darlene, do you want to add anything in here in terms of best practices

Darlene Hernandez:

For record keeping and storage? Absolutely Tae, it's important to keep those records organized and clean not only for purposes of potential lawsuit, but also if there's any question by any investor the s e C can always go in and perform a forensic audit. So it's always good to have all that information in one place with all the information that you can readily provide.

Tae Kim:

Perfect. All right, so that's it from our content. I wanted to actually thank you so much you guys. I know some of them have been pretty convoluted and hopefully it was entertaining and that it was informative for you to take away for your fund management practices. A couple of future webinars and events that we wanted to mention. Number one this is going to be the next webinar the Free up Capital and fund new deals with Dennis and Kyle from our banking and finance team. They're going to be talking about how to fund these deals in the new normal times. And so definitely check them out. It's October 13th on Tuesday, 11:00 AM Pacific time, and we have our Evolve conference. This will be a virtual conference. It's going to be a very exciting time. Our moderators, Kevin, Kim Nema and Melissa Marella are going to be there.

Nema Dandan, right? That's his last name. Sorry, I don't want to butcher his last name. But anyways they're going to be our moderators. There's going to be a lot of networking events as well as education on September 29th. Please join us. It's going to be a very fun time and if you have any questions, please reach out to us. We're actually we're happy to answer. Okay. So let's see. Do we have any questions? We have one, is the law same for a syndication deal, G P LP and non syndicated deal where all investors are active? Yes, it is the same investors, investors and syndication deal, whether it's one off deal and the non syndicated deals where it's a fund fund aspect, they're all the same investors are investors, and the law applies there. Okay. All right. Okay. So there isn't any other questions. Please reach out to us. It doesn't mean that we're not going to answer. We're definitely happy to answer any other questions that you may have. Oh, here's another one. Do a federal or state court handle litigation in this matter? Darlene, do you want to answer that question?

Darlene Hernandez:

Can you read the question, the full question?

Tae Kim:

Sure. It says, do federal or state courts handle litigation in this matter?

Darlene Hernandez:

Yes, both federal and state.

Tae Kim:

Okay. Maybe if we want to just talk a little bit more about common law as well as the Rule 10 B five and how it applies from both of the state and court, maybe that's, we need a little bit more clarification that that's okay with you, Darlene.

Darlene Hernandez:

Oh, absolutely. So why would anyone choose between state or federal court? The legal short answer is jurisdiction. Federal courts have jurisdiction over any type of federal law, and securities falls within that jurisdiction. So if there is a claim under Rule 10, for example, the fraud claim it automatically could be heard in federal court. There are times where you may want to file in state court, especially if there's any violation of any state blue sky laws, and then you would want to bring it in state court. But as a matter of practice I prefer to bring securities cases in federal court. The courts have a lot more resources in federal than they do in state courts especially in California. So to answer your question, yes, both courts are available.

Tae Kim:

Cool. Okay. All right, guys, thank you again for joining us. Please reach out to us for any other questions. Have a wonderful rest of your day, and thank you again.

Darlene Hernandez:

Bye. Thank you.

Questions about this webinar? Reach out to our team below.
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