Equity Trust Notches a Rare Defense Win in SEC Administrative Proceedings

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On June 27, 2016, SEC Administrative Law Judge Carol Fox Foelak dismissed the Division of Enforcement’s charges against IRA custodian Equity Trust Company in connection with the company’s processing of investments marketed by two convicted fraudsters.  Judge Foelak’s decision—a complete defense victory for Equity Trust—shows that while the Division of Enforcement may still win most of its cases in administrative proceedings, it doesn’t win them all.

Equity Trust is a custodian of “self-directed individual retirement accounts” (“SDIRAs”), a type of IRA that permits investments in assets other than publicly traded stocks and bonds, such as real estate and promissory notes.  Equity Trust marketed itself as a passive custodian that acted only to administer its clients’ investments, and claimed that it did not owe any fiduciary duties to its clients, who were responsible for making their own investment decisions.

Equity Trust’s customers included investors who used the funds in their SDIRAs to purchase promissory notes issued by entities controlled by Ephren Taylor and Randy Poulson.  Taylor and Poulson purported to offer investors higher returns and more control over their investments.  But contrary to what they told investors, Taylor and Poulson used the proceeds from these investments to pay off personal and corporate expenses.  Both Taylor and Poulson were convicted of mail and wire fraud.

The Division of Enforcement contended that notwithstanding Equity Trust’s claim that it was a mere passive custodian, the company violated Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 by causing and facilitating Taylor’s and Poulson’s fraud.  First, the Division claimed that the company took an active role in marketing Taylor’s and Poulson’s offerings.  This included appearing at Taylor’s and Poulson’s events, sponsoring events for Taylor and Poulson, and providing Taylor and Poulson its proprietary materials.  The Division also sought to prove that Equity Trust ignored red flags regarding Taylor and Poulson that were raised during the company’s investment review process.  The Division also proffered expert testimony in an attempt to show that Equity Trust breached fiduciary duties owed to its investors.

Equity Trust argued that the administrative proceedings were unconstitutional because the SEC appoints administrative law judges in a manner inconsistent with the Appointments Clause.  Judge Foelak summarily dismissed this argument, noting that the Commission had rejected this contention in other matters.  She also rejected Equity Trust’s argument that the case was constitutionally defective because of a lack of due process and a right to a jury trial, noting that Equity Trust cited no authority to support these arguments.

Turning to the Division’s substantive allegations, Judge Foelak held that Taylor’s and Poulson’s actions constituted violations of Section 17(a) (2) and Section 17(a) (3) of the Securities Act, and that Equity Trust facilitated their fraudulent schemes.  However, Judge Foelak went on to conclude that the Division had not met its burden of proof to establish that Equity Trust knew or should have known of Taylor’s and Poulson’s fraud.   While the Division had presented evidence indicating that Equity Trust knew that Taylor’s business was in financial trouble, Judge Foelak found that “knowing that [Taylor’s business] was financially pressed and losing money is not the same as knowing that Taylor was engaged in fraud.”  Judge Foelak further rejected the purported standard of care for SDIRA custodians proffered by the Division, finding that even if it “may be desirable policy,” it was “essentially made up of whole cloth.”  Finally, Judge Foelak noted that even if Equity Trust had abided by the standard of care urged by the Division, it still would not have known about Taylor’s and Poulson’s fraud.

As we have previously reported, the constitutionality of the SEC’s use of administrative proceedings has been challenged in a number of recent lawsuits.  One of the driving forces behind these lawsuits has been the conventional wisdom – commonly held among the defense bar – that the Division almost always wins in administrative proceedings.  While the Division’s loss in this case undoubtedly stings, the Division may also point to this decision to argue that defense wins in administrative proceedings, rare though they may be, are not impossible.