US judge opens crack in SEC immunity to fraud victim lawsuits

The US Securities and Exchange Commission is learning the hard way that the 7,000 victims of Allen Stanford’s $7.2 billion fraud refuse to slink quietly away with the pittance they’ve recovered from the cases various receivers, trustees and government agencies have brought since the 2009 implosion of the global scheme.

Now, a US district judge, in Miami, has lifted their hopes, albeit slightly and opened the possibility that a federal regulatory agency may be held responsible for losses they suffered when it fails to follow a mandatory duty the law imposes. The lifted hopes come in a ruling by Judge Robert Scola that opens a crack in the heretofore impenetrable wall of government immunity from lawsuits, except in very limited circumstances. “Sovereign immunity” protects regulatory agencies from many lawsuits, including those by persons who suffered from the consequences of regulatory neglect of supervisory responsibilities over financial institutions.

The landmark ruling by Judge Scola comes in the form of a denial of a motion by the SEC to dismiss a lawsuit by two Stanford victims. Although the victims still face other hurdles under the Federal Tort Claims Act (Title 28, USC Section 2671), the initial victory is a landmark.

Lawsuit alleges SEC failure to perform ‘nondiscretionary’ function

The suit was brought by Carlos Zelaya and George Glantz, who lost $1.65 million that they invested in fraudulent certificates of deposit offered by the Stanford Group Company, which had been registered with the SEC. The suit asserts that the SEC is liable because it failed to perform a “nondiscretionary duty.” In this case, the victims allege that the SEC failed to refer the Stanford company to the Securities Investor Protection Corporation after it determined the company was operating a Ponzi scheme a decade before the fraud imploded in 2009.

The plaintiffs allege that SEC examiners uncovered evidence of the fraud during examinations of the Stanford Group Company in 1997, 1998, 2003 and 2004 and did not refer the company to the SIPC.

In his September 7 order, Judge Scola said, “The Securities and Exchange Commission was obligated to report Stanford’s company to the Securities Investor Protection Corporation [SIPC]. This obligation… was not discretionary because the controlling statute mandates that the report be made.”

The case has gone further than any other suit against the SEC by fraud victims has gone, says David Chase, who previously worked as an attorney at the SEC’s Enforcement Division in Washington and is now a Ft. Lauderdale-based private attorney specializing in securities cases.

“This case is obviously significant because an SEC lawsuit has moved beyond the motion to dismiss for the first time,” Chase says. “Other fraud suits against the SEC, such as those related to Madoff, were killed very early on.”

Stanford victims may now gather ammunition against SEC

The Scola ruling allows Stanford victims to proceed with discovery, which may give them evidence to prove the SEC was aware of the details of Stanford’s fraud. Scola did not rule on this question, saying it was better resolved in subsequent steps.

“Plaintiffs will now have a vehicle to engage in discovery – to take depositions of current and former SEC officials, and find out what the agency knew and when. Just that ability alone could be very powerful,” says Chase.

The plaintiffs must file an amended complaint by September 21, and the SEC must respond in 14 days.

The SEC sued Stanford in February 2009 for running a “massive fraud” at the Houston-based Stanford Group Company and Stanford International Bank, in Antigua. In addition to the SEC civil suit, Stanford was arrested by the FBI on criminal fraud charges and sentenced to 110 years in federal prison in June 2012.

Ruling cracks SEC shield of “sovereign immunity”

Zelaya and Glantz brought their suit under the Federal Tort Claims Act (FTCA), a 1946 law that allows US citizens to sue government agencies. Under this law, government agencies have “sovereign immunity” from liability for discretionary acts, but may be held liable in some cases for failing to perform “nondiscretionary duties.”

In its February 14 motion to dismiss, attorneys for the US urged dismissal of the case on the grounds the SEC was immune from liability under the law because its decision to take regulatory action against Stanford was wholly discretionary.

“The SEC enjoys complete discretion under the 1934 Securities Exchange Act in deciding whether and how to investigate suspected wrongdoing,” argued Justice Department attorneys. “Based on these sweeping grants of authority, courts have uniformly dismissed FTCA suits challenging SEC decisions regarding whether and how to investigate alleged wrongdoing.”

The attorneys added, “The challenged conduct here involves matters committed to the SEC’s discretion. Although Plaintiffs seem to challenge the SEC’s failure to take some sort of enforcement or regulatory action against Stanford at an earlier date, rather than the manner in which the SEC conducted its investigations of Stanford, … the SEC enjoys complete discretion under the 1934 Securities Exchange Act in deciding whether and how to investigate suspected wrongdoing.”

Scola agreed that the SEC had the discretion to renew or not renew the Stanford Group Company’s annual registration and could not be sued for continuing to renew it even after it found evidence of fraud there.

Judge unswayed by US claim that Ponzi schemes are not insolvent

But on the question of whether the SEC had any latitude to report the Stanford Group Company to the SIPC, Scola ruled that the SEC had no discretion, but was clearly mandated by law to do so. The Securities Investor Protection Act requires the SEC to report broker-dealers if it determines they are “in or approaching financial difficulty.” (Title 15, USC Sec. 78eee(a)(1))

Justice Department attorneys argued that operating a Ponzi scheme did not necessarily mean that Stanford’s company was in “financial difficulties.” They asserted that even if Stanford was running a fraud, the SEC was not obligated to report it to the SIPC because that is not tantamount to experiencing “financial difficulties.”

Scola was not impressed with that logic. He ruled that Ponzi schemes are by their nature financially insolvent. “The Government’s argument that a determination that Stanford’s company was operating as a Ponzi scheme is not the same as a determination that the company was in or approaching financial difficulty is not convincing,” he said.

The SIPC, a quasi-government agency supervised by the SEC, is designed to protect investors in failed or insolvent broker-dealers. It performs functions similar to those of the Federal Deposit Insurance Corporation (FDIC) in the banking sector.

Plaintiffs face long road to recovering from SEC

In attempting to prove the SEC slept while Stanford’s megafraud was unfolding, the plaintiffs may find an ally in the SEC. A 2010 report by then-SEC Inspector General David Kotz reviewed the agency’s oversight of the Stanford Group Company and criticized the SEC for failing to fully investigate Stanford despite years of suspicions and mounting evidence. The report suggested that SEC examiners knew Stanford’s operations were “likely a Ponzi scheme” after their 1997 examination.

“That’s a very helpful report for these plaintiffs, possibly more helpful than this court ruling,” says Kirk Smith, a partner at Shepherd Smith Edwards & Kantas, in Houston, who focuses on securities issues.

He cautions against reading too much into the Scola ruling, saying the SEC’s failure to report Stanford to SIPC may mean little in terms of its ultimate liability to fraud victims.

“The SEC may have had a duty to tell SIPC, but it’s a well-established fact that SIPC doesn’t cover fraud losses,” Smith says. “[The plaintiffs] still have a long way to go.”

The attorney for the plaintiffs against the SEC, Gaytri Kachroo of Kachroo Legal Services in Boston, said “The ruling handed down (by Judge Scola) is a bold statement and a warning to the government: if you fail to carry out your statutory obligations to protect the public against wrongdoing with massive repercussions to the investing public, you will be held liable.”