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SEC ‘zombie claims’ not revived by new law, penny-stock fraud defendants argue

The seal of the U.S. Securities and Exchange Commission at their headquarters in Washington, D.C., U.S., May 12, 2021. REUTERS/Andrew Kelly

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(Reuters) – Congress did a favor for the U.S. Securities and Exchange Commission in this year’s defense spending bill, giving the SEC 10 years instead of just five to bring disgorgement claims against fraudsters.

But according to two defendants in an SEC lawsuit alleging a sweeping penny-stock fraud scheme, lawmakers did not empower the agency to revive claims that were dead by the time the new law passed.

Defense lawyers from Vedder Price and DLA Piper argued in dismissal motions filed on Wednesday for Graham Taylor and Paul Sexton that the clock ran out at least a year before Congress extended the deadline for SEC disgorgement claims in the National Defense Authorization Act. (Yes, weirdly, after intense lobbying by then-SEC Chair Jay Clayton, lawmakers stuck the SEC provision in the must-pass defense spending bill, which took effect on Jan. 1.)

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The defendants contend that the specific language of the disgorgement extension does not authorize the SEC to apply the provision retroactively to expired claims – and that the SEC’s attempt to wield the law against targets who were in the clear is not only fundamentally unfair but also a potential violation of the Constitution’s ex post facto clause.

“Why do we have a statute of limitations in the first place?” said Taylor counsel Michael Quinn of Vedder Price. “To be free of any of this for two-and-a-half years, and then to have it come back, strikes me as just wrong.”

The SEC didn’t respond to my email query on the Taylor and Sexton motions but argued in response to another defendant’s protest against the NDAA’s retroactive application that the text of the statute specifically extends the disgorgement deadline in any case commenced after Jan. 1, 2021. The penny-stock case was filed in August, the SEC said, so the longer statute of limitations applies.

The SEC also said the Constitution’s ex post facto clause prohibits the retroactive application only of laws addressing criminal acts, not civil enforcement proceedings.

The SEC’s complaint in federal court in Boston casts Taylor and Sexton as secondary players in a multinational scheme to manipulate penny-stock prices via surreptitious share sales by controlling shareholders. The control groups allegedly used offshore shell companies, foreign bank accounts and secret phone lines to dump shares in the over-the-counter market.

Both Taylor and Sexton argued that the SEC complaint does not plausibly allege any wrongdoing by them after 2014 or 2015. (The government claims that other members of the scheme continued the fraud until at least 2019.) There’s no question, their dismissal briefs argue, that the SEC waited too long to demand a monetary penalty from them, since the NDAA did not extend the five-year statute of limitations for SEC penalty claims. The provision only addresses disgorgement in SEC lawsuits alleging fraudulent intent, undoing the five-year time limit on disgorgement claims that the U.S. Supreme Court imposed in 2017’s Kokesh v. SEC.

So the question is whether the language in the NDAA provision — which says the extension applies to proceedings initiated after the law’s enactment — applies retroactively to reanimate dead claims. Taylor and Sexton argued that it does not under the Supreme Court’s test in 1994’s Landgraf v. USI Film Products. Congress did not expressly call for the law to allow the SEC to bring back zombie claims, the dismissal briefs said, and ambiguity is supposed to be resolved in defendants’ favor.

When Congress enacted the Sarbanes-Oxley Act in 2002, it used language similar to the text of the NDAA’s disgorgement provision to extend the statute of limitations on some securities fraud claims. The 2nd U.S. Circuit Court of Appeals ruled in an influential 2004 decision in In re Enterprise Mortgage Acceptance that the Sarbanes-Oxley statutory extension could not be used to revive claims that were dead when the law was passed because Congress did not unambiguously specify the provision’s retroactive application.

Taylor and Sexton argued that the same reasoning should prevail in their case – all the more so, argued Sexton’s lawyers at DLA Piper, because Congress should have known how courts have interpreted Sarbanes-Oxley when lawmakers adopted substantially identical language in the NDAA.

The defendants asserted their ex post facto clause argument as a backup, insisting that even though the SEC’s enforcement action is a civil case, the SEC uses disgorgement to penalize targets so the constitutional clause applies. The SEC noted in its brief opposing a different defendant’s dismissal motion that in September a federal judge in Los Angeles rejected parallel ex post facto arguments about the NDAA provision. But the Sexton brief argued that there are enough doubts about the constitutionality of using the NDAA provision to revive dead claims that the judge in the penny-stock case, U.S. District Judge William Young, “should avoid interpreting the NDAA in a manner that could potentially result in an ex post facto punishment.”

Young’s interpretation of the retroactive effect of the NDAA’s disgorgement provision, said Taylor counsel Quinn, will reverberate beyond the penny-stock case as the SEC brings more enforcement actions based on disgorgement claims that were dead before the new law was enacted. “This is the first case,” Quinn said. “It won’t be only one, for sure.”

Read more:

Congress hid a big gift to the SEC in defense spending bill awaiting Trump’s signature

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Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A Dartmouth college graduate, she has worked as a journalist in New York covering the legal industry and the law for more than three decades. Before joining Reuters, she was a writer and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.