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A Securities Fraud Case For The Textbooks

On July 29, 2009, the Ninth Circuit United States Court of Appeals issued an opinion in the case Desai v. Deutsche Bank Securities Limited, a securities fraud class action in which the Ninth Circuit affirmed the district court's denial of plaintiffs' motion for class certification. More important than the Court's decision on the motion for class cert., however, was the fact that this case, as aptly recognized by the Ninth Circuit, "stages the last act of a long drama that followed the collapse of an elaborate stock manipulation scheme."

The "scheme" the Court is referring to involved the stock of a company known as GenesisIntermedia, Inc. ("GENI"), and affected some of the largest broker-dealers in the world. It came to light after events of September 11, 2001, for reasons still not fully understood today, impacted the scheme in such a way that the underlying fraud became apparent. Needless to say, a full recitation of all the players involved would required pages upon pages of discussion, but any story that include arms dealers, rogue stock traders, paid-off analysts, falsified documents, fraud, and hundreds of millions of dollars doesn't come around every day. Who says securities fraud litigation isn't sexy?

Intrigue aside, the heart of the scheme was deceptively simple and involved a relatively commonplace practice called stock lending, which the Ninth Circuit succinctly explained as follows:  "In the typical securities loan, a broker-dealer lends securities to another broker-dealer, the loan being secured by cash collateral the borrower gives to the lender.  The borrower of the security receives so-called rebate payments, which are like interest on the cash collateral he has transferred to the security lender.  As the value of the security increases, the amount of cash collateral and the level of interest also increase.  Adjustments - marking the securities to the market - are made daily."

The problem with the GENI stock lending scheme is that it was entirely fraudulent and violated nearly every core securities law. According to the Ninth Circuit's opinion, shareholders of GENI issued themselves unregistered shares (which cannot be resold to the public) and sold those shares to another broker dealer, Native Nations (also in on the scheme), which then falsified records so that the shares appeared to have been received from other broker dealers. Native Nations then lent the shares to other broker dealers (not in on the scheme) under the guise of routine stock lending between member firms. The scheme was orchestrated by individuals on both ends of the chain, i.e. GENI shareholders and a rouge trader, Wayne Breedon at Deutsche Bank. The real tragedy is that unsuspecting broker-dealers who thought they were receiving and on-lending securities exempt from registration were caught in the middle.  A casualty of the fall-out was local broker dealer MJK Clearing, Inc., which was forced into bankruptcy after market forces in September 2001 prompted the lenders in the stock lending chain to return their shares of GENI (whose stock price had tanked by this time). Unable to return the worthless GENI shares to Native Nations and other broker dealers closer in the chain to GENI, and after having already returned cash to other broker-dealers further away from GENI in the chain, MJK was forced to cease operations.

This case (and perhaps to a greater extent the companion cases heard in the Federal District Court in Minnesota) contain intrigue that rivals any best seller. If there was a book entitled "How to Completely Violate the Federal Securities Laws" these cases would be in Chapter 1.

At the end of the day, while the courts' opinions from these cases will likely find their way into securities course classroom discussions, they are worth a read, if only to see how creative ingenuity in the wrong hands can wreak havoc on the securities markets and some of its largest participants.

Full post as published by OverRegd - Securities Regulation and Litigation Blog on August 05, 2009 (boomark / email).