The Commission suffered a significant loss in a recent decision by the Eleventh Circuit Court of Appeals. The Court constricted the reach of Exchange Act Section 10(b) and tightened the standards for issuing an injunction, precluding "obey the law" orders which have long been a staple of SEC enforcement. SEC v. Goble, No. 11-12059 (11th Cir. May 29, 2012).
The action arose out of a FINRA inspection of North American Clearing, Inc., a securities and clearing brokerage firm founded by Richard Goble in1995. In March 2008 the regulator began an audit of North American. During the course of that audit examiners uncovered a series of irregularities in the reserve computations made by Timothy Ward, the CFO of the firm. The mistakes were corrected.
The auditors also uncovered a sham transaction in the reserve account. Specifically, as the firm's cash flow difficulties increased, and in the wake of being denied a $5 million unsecured loan, a transaction was booked which made it appear on paper that North American could withdraw money from its reserve account. The rules permit the firm to make a withdrawal from that account after balancing customer credits and debits if the balance exceeds what is required. Here the firm booked a transaction to make it appear the balance exceed what is required. In fact the transaction was a sham booked by Mr. Ward at the direction of Mr. Goble with assistance by Bruce Blatman, the CEO of the company. The transaction was reversed.
Subsequently, the SEC brought an enforcement action against North American, and Messrs. Goble, Blatman and Ward. The complaint alleged violations of Exchange Act Sections 15(c)(3) and 17(a), claiming that North American violated the customer protection and books and records provisions and that the individual defendants aided and abetted those violations. It also claimed that each of the defendants violated Exchange Act Section 10(b).
The firm and defendants Ward and Blatman settled with the Commission. Following a five day bench trial the district court concluded that Mr. Goble liable on each count. An injunction was entered based on each of the Sections cited in the complaint. He was also barred from the securities business.
The Circuit Court reversed two key ruling of the district court. First, the Court rejected the determination of the district court that the sham transaction constituted a violation of Exchange Act Section 10(b). For the SEC to prove a violation of that Section, the agency must establish that the misrepresentation is material. Materiality is defined in terms of the total mix of information important to a reasonable investor in making an investment decision. Here the district court found, and the SEC argued, that knowing information about the sham transaction would be important to a reasonable investor's choice of broker-dealer. The Circuit Court however, declined to expand its definition of materiality to include such a misrepresentation. Rather, it concluded that "a misrepresentation that would only influence an individual's choice of broker-dealers cannot form the basis for §10(b) liability.
The Court bolstered its conclusion with two additional points. Here the SEC failed to establish that the sham transaction was "in connection with" the purchase and sale of a security as required by the Section. Likewise, the Court found that "Section 10(b) was not intended to protect investors from a broker-dealer's inaccurate records or an inadequate reserve fund. The Court thus reversed the injunction prohibiting future violations of Section 10(b).
Second, the Court vacated the injunction based on Exchange Act Sections 15(c)(3) and 17(a). The text of the injunction was little more than a recitation of the statutory language coupled with a citation to the pertinent Sections and related rules. This is noting more than an "obey-the-law" injunction. The Court has repeatedly quested this type of injunction for lacking the type of specificity required by Federal Rule 65(d)(1). Contained within the four corners of the injunction should be specifications to inform the person enjoined what is prohibited. If, for example, the "injunction simply used the language of §10(b) of the Exchange Act or Rule 10b-5, a defendant reading the injunction would have little guidance on how to conform his conduct to the terms of the injunction. Indeed, that defendant would need to review hundreds of pages of the Federal Reporters, law reviews, and treatises before he could begin to grasp the conduct proscribed by §10(b) and in turn the injunction." This does not comply with Rule 65 the Court held.
At the same time the Court acknowledged that the securities laws contain specific provisions authorizing the entry of an injunction as a remedy. While the injunction may be broad, it must meet the specificity requirement of Rule 65(d) and clearly inform the defendant what he is ordered to do and not to do. The Court thus "reject[ed] the SEC's implied contention that the injunction need not inform the defendant of precisely what conduct is forbidden."
Lexis.com subsribers can access Lexis enhanced version of the SEC v. Goble, 2012 U.S. App. LEXIS 10813 (11th Cir. Fla. May 29, 2012) decision with summary, headnotes and Shepard's.
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