Enforcement News: SEC Brings Emergency Action to Stop $125 Million Offering, The Misappropriation of Investor Funds, and Ponzi-Like Fraud

• Posted on: Sep 23 2019

This Blog has often noted that “securities fraud comes in all shapes and sizes.” (E.g., here.) Though the alleged fraudulent scheme may differ, the types of schemes implemented tend to fall into one of the following (non-exclusive) categories: financial statement/accounting fraud; pyramid schemes; Ponzi schemes; pump-and-dump schemes; affinity fraud; promissory note fraud; Internet fraud; “microcap” stock fraud; and fraud concerning information about a company, its operations and future prospects (id.).

Many of the techniques used by alleged wrongdoers are designed to persuade a target or victim into buying the security at issue. Some of these techniques include: (1) phantom riches representation – that is, the investment will yield “incredible gains,” is a “breakout stock pick” or has “huge upside and almost no risk”; (2) guaranteed returns – that is, high returns and low risk are “guaranteed” or “can’t miss”; (3) source credibility or “halo” effect – the fraudster tries to build credibility by claiming to be with a reputable firm or to have a special credential or experience; (4) “I believe in the company, so should you” assurance – the fraudster tries to assure the target that the investment is a sound one because he/she also invested in the company; (5) “everyone is buying it” representation – the fraudster stresses that other people are buying the security and, therefore, so should the target or victim; and (6) the reciprocity representation – the fraudster offers to do a small favor for the target or victim in return for a big favor: “I’ll give you a break on my commission if you buy now.”

In today’s post, this Blog looks at SEC v. Mediatrix Capital Inc., 1:19-cv-02594-RM (D. Colo. Sept. 12, 2019), an enforcement action brought by the U.S. Securities and Exchange Commission (“SEC” or the “Commission”) in which the defendants are alleged to have employed many of the foregoing techniques to place at risk more than $125 million of investors’ funds.

According to the SEC, from March 2016 to the present (the “Relevant Period”), Michael S. Young (“Young”), Michael S. Stewart (“Stewart”), Bryant E. Sewall (“Sewall”) (collectively, the “Individual Defendants”), through  Mediatrix Capital Inc. (“Mediatrix Capital”), Blue Isle Markets Inc. (“Blue Isle 1”), and Blue Isle Markets Ltd. (“Blue Isle 2”) (collectively, the “Entity Defendants”), raised more than $125 million from investors in unregistered securities offerings by representing to investors that their money would be pooled and invested using Defendants’ successful and profitable algorithmic trading strategy. Defendants claimed that from December 2013 through at least March 2019, their trading strategy had never had an unprofitable month and had returned more than 1,600%. Defendants further claimed that their trading strategy had enabled Mediatrix Capital to accumulate assets under management of $225 million at the end of 2018. The SEC maintained that none of the foregoing representations were true.

According to the SEC, since mid-2016, Defendants had misappropriated more than $35 million of investors’ money by transferring it out of the Entity Defendants’ bank and brokerage accounts instead of using the money for trading. Defendants purportedly used investors’ money to purchase luxury properties and vehicles and diverted more than $5 million of additional investors’ funds for other expenditures to perpetuate the alleged fraud.

Even when Defendants used the remaining portion of investors’ money for trading, claimed the SEC, Defendants consistently lost money – losing more than $18 million from trading in 2018 alone. Because of Defendants’ alleged misappropriation and trading losses, maintained the Commission, Mediatrix Capital’s assets under management were nowhere near the amounts represented by Defendants. For example, said the SEC, at year-end 2018, Defendants represented that Mediatrix Capital had $225 million under management, when the firm actually had approximately $35.3 million in assets under management (less than 16% of the amount claimed).

To induce investment into the trading strategy, alleged the SEC, Defendants repeatedly misrepresented the profitability of their trading, falsified investors’ account statements to show phantom profits, and made Ponzi-like payments to investors who opted to cash out their “profits” — all in order to prop-up the façade of profitable trading.

The SEC alleged that Defendants made numerous additional, material misrepresentations and omissions to investors regarding the purported transparency of Mediatrix Capital’s trading, as well as third party involvement in verifying trading results. Defendants allegedly falsified investors’ account statements and manipulated trading results to reflect profits rather than the actual losses resulting from their trading. The SEC maintained that Defendants falsely claimed that Mediatrix Capital’s trading results had been audited. Defendants also allegedly made numerous misleading statements implying that Blue Isle 1 and Blue Isle 2 were independent, third-party administrators that received Mediatrix Capital’s trading data directly from brokerage firms before reporting it to investors, when in fact, said the SEC, Defendants owned and controlled the Blue Isle entities and manipulated the trading data they conveyed to investors.

According to the SEC, Defendants’ misrepresentations, omissions, and other misconduct had the same goal and effect: provide investors with a false picture of trading profitability and a false sense of security to induce additional investment and to perpetuate the alleged fraud.

As alleged, Defendants’ misappropriation and trading losses caused the collapse of the fraud. According to the SEC, Mediatrix Capital’s most recent bank and brokerage account records indicated that only a fraction of investors’ funds remained, causing investors to lose tens of millions of dollars of their money.

As a result of the conduct described in the SEC’s complaint, the SEC alleged that Defendants violated Sections 5(a) and (c) and Section 17(a) of the Securities Act of 1933 (the “Securities Act”), 15 U.S.C. § 77e(a) and (c) and §77q(a), and Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5. The Commission also alleged that Mediatrix Capital, Young, Stewart, and Sewall violated Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act 1940 (“Advisers Act”), 15 U.S.C. §§ 80b6(1), 80b-6(2), and 80b-6(4), and Rule 206(4)-8 promulgated thereunder, 17 C.F.R. § 275.206(4)-8, and, in the alternative, Defendants Young, Stewart, and Sewall aided and abetted Mediatrix Capital’s violations of Sections 206(1), 206(2), and 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.

The SEC also named numerous persons and entities as relief defendants because Defendants allegedly transferred millions of dollars of investors’ money to spouses, other relatives, friends, and shell companies they owned or controlled. The SEC claimed that each of the relief defendants received illicit proceeds from Defendants’ fraud to which they had no legitimate claim.

The SEC is seeking permanent injunctions against each of the Defendants, enjoining them from future violations of the securities laws, disgorgement of all Defendants’ and relief defendants’ ill-gotten gains from the alleged unlawful activity, together with prejudgment interest, and civil penalties against Defendants under Section 20(d) of the Securities Act, 15 U.S.C. § 77t(d), Section 21(d)(3) of the Exchange Act, 15 U.S.C. §78u(d)(3), and Section 209(e) of the Advisers Act, 15 U.S.C. § 80b-9(e).

Commenting on the allegations, Kurt L. Gottschall, Director of the SEC’s Denver Regional Office, said: “We allege that this scheme has resulted in tens of millions of dollars in investor losses, in part, to fund defendants’ luxurious lifestyle. The SEC will do all it can to hold these defendants accountable and ensure money is returned to those who were deceived.”

The SEC press release announcing the commencement of the action can be found here.

The SEC Complaint can be found here.