Securities Regulation Daily Reg D’s safe harbor causes part of SEC’s case to run aground
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Thursday, February 23, 2017

Reg D’s safe harbor causes part of SEC’s case to run aground

The Eleventh Circuit has partially reversed a grant of summary judgment to the SEC in an enforcement action against George Levin for fraudulently selling unregistered notes connected to the Rothstein Ponzi scheme. The language and history of Regulation D persuaded the court that the safe harbor provision of Rule 508(a) is available to private note offerings in SEC enforcement actions. As Levin had established a genuine dispute of material fact on whether his securities offerings fell within the safe harbor, the award of summary judgment on the registration claim was reversed. The appellate court upheld the $40 million disgorgement award against Levin, however, reasoning that the district court properly based the award on Levin’s ill-gotten gains from the fraud (SEC v. Levin, February 23, 2017, Dubina, J.).

Rothstein Ponzi scheme. Scott Rothstein had used his law firm, Rothstein, Rosenfeldt and Adler P.A. to solicit investors to purchase confidential settlement agreements supposedly reached in sexual harassment or whistleblower lawsuits. No such agreements existed, and the investors were paid with funds from other investors. The scheme collapsed in October 2009, and Rothstein pleaded guilty to wire fraud, racketeering conspiracy, and other charges.

According to the SEC, Levin began using his dormant legal entity, Banyon 1030-32, to purchase the fictitious settlements from Rothstein. Beginning in late 2007, Banyon offered investors promissory notes, personally guaranteed by Levin, stating that the funds collected would be used to purchase settlements from Rothstein. The promissory notes were unregistered and no exemption from registration applied. Banyon investors lost $40 million when the scheme collapsed.

The SEC then filed suit against Levin in May 2012, alleging that Levin had sold unregistered securities in violation of Section 5 of the Securities Act and had engaged in fraud in violation of the Exchange Act. In his answer, Levin asserted that the Banyon promissory notes were exempt from registration either because: (1) they did not involve any public offering under Rule 506(b) of Regulation D; or (2) because they were protected by the safe harbor provision of Rule 508 of Regulation D. The SEC countered, however, that Levin could not avail himself of the Rule 508(a) exemption because this exemption is applicable only in private actions, not SEC enforcement actions under the Securities Act. After the trial court ultimately granted summary judgment for the SEC on the exemption issue, a Florida jury returned a verdict against Levin.

"Failure to comply." The court noted that Rule 508 provides a safe harbor in private offering actions when there are "insignificant deviations" from Rule 506(b). Rule 508(a) provides that a deviation will not result in the loss of the exemption if: (1) the deviation does not pertain to a requirement designed to protect the purchaser; (2) the deviation is insignificant with respect to the offering as a whole; and (3) a "good faith and reasonable attempt" has been made to comply with all Rule 504, 505, and 506 requirements. Rule 508(b) states, however, that where an exemption is established only under Rule 508(a), "the failure to comply" is nonetheless actionable by the Commission under Securities Act Section 20.

The SEC argued that it was "the failure to comply" with the registration requirements of Section 5 that was actionable. The Eleventh Circuit, however, sided with Levin, who argued that "the failure to comply" referred to individual failures to comply with Rules 504-506, leaving the protection of the exemption in place for the Section 5 violation generally.

Looking first to the language of the regulation, the court observed that the phrase "failure to comply" appears numerous times in Rule 508. Given Rule 508(a)’s repeated references to "failure to comply" in the context of compliance with the Rules of Regulation D for private offering exemptions, it follows that the phrase "failure to comply" in Rule 508(b) must also be interpreted to relate to compliance with Rules 504-506 of Regulation D and not to compliance with Section 5.

Second, if the SEC had intended for Rule 508(b) to address non-compliance with Section 5, it would have expressly stated so, the court reasoned. This is true especially because Rule 508(a), part of the same rule, explicitly references Section 5 of the Securities Act. Third, the inclusion of the first sentence of Rule 508(b) adds meaning only if it is interpreted as allowing the SEC to bring Section 20 enforcement actions for specific violations of the rules of Regulation D, not of Section 5, even where Rule 508(a) good faith compliance applies. Otherwise, the sentence is not necessary.

The appellate panel noted that the regulatory history of regulation D also lends support for this interpretation. Accordingly, based on the plain language of the regulation and the regulatory history, the court held that Rule 508(a) not only preserves the safe harbor for certain insignificant deviations in private actions, but it also preserves the safe harbor in SEC enforcement actions. As there were disputed facts about whether the Banyon notes were eligible for a Rule 506 exemption, and, in turn, fell within the safe harbor provision of Rule 508, the district court erred in granting summary judgment to the SEC on the registration claim. Accordingly, the grant of summary judgment was reversed and the matter was remanded for further proceedings.

Disgorgement award. The appellate court affirmed, however, the district court’s entry of a $40.1 million disgorgement award against Levin. Levin claimed that the district court should have reduced the disgorgement award by $30.4 million, the amount distributed by the Banyon bankruptcy trustee to Banyon’s investors. This amount did not come out of Levin’s gains, however, but instead came from a settlement with a bank for Banyon’s investment in the fraud. Hence, this money was not a return of investor proceeds raised during the Banyon offering, and the district court properly did not consider these funds to offset the disgorgement.

Moreover, the court continued, there was no evidence that the $1.75 million Levin contributed from his personal bankruptcy estate has yet reached the hands of Banyon investors. If it does, then Levin could petition the district court at that time for a reduction in the disgorgement award because the recovery would constitute a partial return of Levin’s ill-gotten gains.

The case is No. 15-14375.

Attorneys: Jeffrey Alan Berger for the SEC. Michael Anthony Pineiro (Marcus, Neiman & Rashbaum, LLP) for George G. Levin.

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