Wednesday, October 24, 2018
An SEC administrative law judge recently rejected some of the SEC’s fraud charges against hedge fund manager RD Legal Capital, LLC and its owner Roni Dersovitz (“Respondents”) by finding that the SEC did not prove that Respondents made certain material misrepresentations and failed to establish that other alleged material misrepresentations were made with scienter. In the Matter of RD Legal Capital, LLC, and Roni Dersovitz, File No. 3-17342, Initial Decision (Oct. 15, 2018). While ALJ Jason S. Patil did conclude that Respondents were liable for negligence-based fraud violations, his rulings with respect to the scienter-based charges and the drastically-reduced penalties he ordered were largely a defeat for the SEC.
In July 2016, the SEC instituted proceedings alleging, among other things, that Respondents defrauded investors by misrepresenting the types of legal receivables in which two funds managed by RD Legal Capital invested. Id. at 2. In particular, the SEC alleged that Respondents violated the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 by representing that the legal receivables invested in by two of their hedge funds all arose out of binding settlement agreements or judgments and therefore posed no litigation risk, when in fact four categories of legal receivable investments “involved matters that had not settled or reached final judgment at the time of the investments, or . . . were purchased from entities other than law firms.” Id. at 9. Those four categories were: (1) “purchases of attorneys’ and plaintiffs’ receivables arising from the 1983 Beirut barracks bombing” (the “Peterson receivables”); (2) “receivables of attorney Daniel Osborn” (the “ONJ receivables”); (3) “receivables of Barry Cohen” (the “Cohen receivables”); and (4) “receivables arising out of the 2010 oil spill in the Gulf of Mexico” (the “Deepwater Horizon receivables”).
In challenging Respondents’ representations to investors, the SEC specifically focused on the statements made in Respondents’ offering memoranda, marketing materials, investor-directed materials (such as Respondents’ website), and Form ADVs, as well as their conversations with investors. However, Respondents argued “that they were permitted under the offering memoranda,” which contained “flexibility provisions,” “to make the investments challenged by the Division and, to the extent that other written or oral statements to investors were contradicted by the clear language in the offering memoranda, the terms of the offering memoranda control.” Id. at 59.
In deciding whether Respondents made material misrepresentations, Judge Patil found that he “should begin with consideration of the terms of the offering memoranda.” Id. He agreed with the SEC that those documents “gave investors the distinct impression that the Funds were invested exclusively in legal receivables from cases that were resolved by settlement, an agreement between parties, or, in some instances a judgment against a debtor—with little to no litigation risk,” and that “no offering memorandum ever advised a reader that the Funds had ever purchased a legal fee arising out of anything other than a settlement or judgment.” Id. at 59-60. Judge Patil also found that these impressions were reinforced by some of Respondents’ marketing materials and “[o]ther oral and written representations.” Id. at 62. Nevertheless, he determined that these statements were materially inaccurate only as a result of the ONJ and Cohen receivables, which presented a “different class of risks associated with contingent litigation-based receivables,” id. at 78, and found “that the Division failed to establish by a preponderance of the evidence that the statements were materially false or misleading with respect to the Peterson and Deepwater Horizon” receivables. Id. at 63.
Regarding the Deepwater Horizon receivables, Judge Patil held that “the opportunity was consistent with one of the emerging opportunities the Fund manager could reasonably take advantage of under the terms of the offering memoranda’s flexibility provision,” because, while the monies associated with these receivables were not advanced to attorneys, the settlement in that matter authorized “non-attorney representatives . . . to file claims against a settlement fund,” thus making them “something of a surrogate for law firms for purposes of the settlement process,” and otherwise, “the investments were . . . substantially similar to the core investments of the Funds.” Id. at 65-66. With respect to the Peterson receivables, which were the “[t]he focus of the Division’s case,” id. at 70, Judge Patil concluded that “[n]either the Division nor Respondents have convinced me,” and because the Division “bears the burden of proof or persuasion . . . the Division has not proved by a preponderance of the evidence that Respondents’ misrepresentations were material with respect to Peterson.” Id. at 78.
Next, Judge Patil found that, while Respondents made material misstatements concerning the ONJ and Cohen receivables, those misstatements were not made with scienter. Specifically, he reasoned that the following factors “rebut the allegation of scienter”: (1) Respondents’ provision of “quarterly ‘Independent Accountant’s Report[s] On Applying Agreed-Upon Procedures,’ which included detailed information concerning troubled assets . . . including the ONJ and Cohen investments;” (2) Respondents’ provision of “annual audited financial statements that identified the Funds’ top concentration of investments by payor;” (3) the hosting on Respondents’ website of documents “pertinent to the Funds, including the offering memoranda, subscription documents, financial statements, AUPs, and investor communications;” (4) the availability of “a detailed collection of information with respect to the legal receivables agreements;” and (5) the absence of a “policy or practice of denying or providing false information.” Id. at 80-82. In short, Judge Patil found that there was no “intent to deceive because Respondents did not attempt to hide the investments.” Id. at 81. Furthermore, he determined that Respondents’ conduct “did not rise to the level of extreme recklessness,” because, while “the most troubling misstatements were the express disclaimers of litigation risk in the” due diligence questionnaires, those questionnaires are “marketing materials, which investors should treat skeptically,” and “the misstatements were in answer to a question about the Funds’ strategy,” which Respondents testified did not include the ONJ and Cohen receivables, as they were “one-off workouts of other, strategy-compliant positions that had gone wrong.” Id. at 87. As a result of these findings, the SEC’s most serious claims—those under Section 10(b) and Rule 10(b)-5 of the Exchange Act and Section 17(a)(1) of the Securities Act—were dismissed.
However, while Judge Patil recognized that “the Division focused most of its efforts on supporting its claims requiring scienter,” he determined that the Division “did not thereby forfeit or waive its claims based on negligence.” Id. at 84. He further found that there was “sufficient evidence in the record regarding the standard of care to conclude that Respondents did not meet that standard,” and were therefore negligent in making material misrepresentations with regard to the ONJ and Cohen receivables. Id. Specifically, he concluded “that the offering memoranda language with respect to all legal receivables arising from settlements and judgments represented an inaccuracy that is inconsistent with the reasonable care a hedge fund should take when it in fact had substantial positions in receivables based on pending litigation.” Id. at 86-87. As a result, Respondents were found liable under Sections 17(a)(2) and 17(a)(3) of the Securities Act.
Because he determined that Respondents did not act with scienter and it was shown that Respondents were not unjustly enriched and that most investors actually profited from their investments, Judge Patil found that only half of the maximum per-violation civil penalties were warranted. He based the penalties assigned to Respondents on the number of documents containing “actionable misrepresentations” and concluded that RD Legal Capital and Dersovitz should be fined $575,000 and $56,250 respectively. Id. at 96-97. In doing so, he rejected the SEC’s argument that Respondents should be penalized “for each defrauded investor who testified . . . as it could be based on tactical decisions by the Division about how many witnesses to call and who was available to testify.” Id. at 96. Furthermore, Judge Patil determined that disgorgement was not warranted, finding that to award the disgorgement of over $56 million sought by the SEC “may trigger constitutional scrutiny.” Id. at 98. Finally, while he also entered a cease and desist order and suspended Dersovitz from the securities industry for six months and prohibited him from working for an investment company for the same time period, Judge Patil declined to enter the permanent industry bar sought by the SEC.
While the SEC suffered several defeats in this case, it is important to note that despite being unable to prove that the Respondents acted with scienter, the SEC was able to hold Respondents liable for negligence-based charges. Because of the SEC’s ability to bring negligence-based charges, investment advisers must be extra vigilant about their disclosures and in ensuring that their trading practices are consistent with those disclosures.
Nevertheless, ALJ Patil’s decision signals that the SEC staff cannot rely on its “home court advantage” in every case. It also demonstrates that the SEC has a significant burden in proving “scienter” under Section 10(b) and Section 17(a)(1). It is also important that ALJ Patil recognized that the lack of scienter drastically affected the financial and non-financial remedies imposed against the Respondents.