The securities laws of the United States “substitute a philosophy of disclosure for the philosophy of caveat emptor,” Justice Arthur Goldberg wrote in a Supreme Court decision nearly half a century ago.
These days “caveat emptor” — let the buyer beware — is staging a comeback. The trustee in the Bernie Madoff caseargues that some people who invested with Mr. Madoff deserve to lose not only the fictitious profits they received but should also lose their original investment. Why? Because they were sophisticated investors who should have known that Mr. Madoff was running a Ponzi scheme.
It is an interesting concept. If you should have known you were being defrauded, you do not deserve the same protection as those who were not sophisticated.
The Supreme Court case involved a publisher of an investment newsletter who failed to mention to his customers that he was making money by buying what he planned to recommend and then selling into the demand he generated.
Both a district judge and the United States Court of Appeals for the Second Circuit concluded that there was no obligation to disclose and refused to grant an injunction requiring the publisher, Harry P. Schwarzmann, and his company, Capital Gains Research Bureau, to either halt the practice or warn investors.
But by a 7-1 vote, the Supreme Court ruled in 1963 that the Securities and Exchange Commission was entitled to the injunction. Later the commission passed a rule requiring such disclosures.
This week, the S.E.C. filed a case that in some ways is an echo of the one that prompted the 1963 ruling, even though the defendant, Wall Street Capital Funding, was careful not to make the mistake that Mr. Schwarzmann did. It disclosed what it was doing.
“This profile is not without bias, and is a paid release,” Wall Street Capital wrote in a typical promotion cited by the S.E.C. The promoter said it had been paid with stock and “intends to immediately continue selling its shares as this release is being circulated.”
That disclosure came in a promotion for a company named PrimeGen, which claimed to have at least a dozen oil wells operating in Russia. In fact, the S.E.C. said, PrimeGen was “a pure scam” whose headquarters was “a rented mailbox in aU.P.S. Store opened with do-not-forward instructions.” Its phone was never answered — and never placed a single outgoing call.
That did not stop the stock from starting at under a penny and jumping to a high of 38 cents, as millions of shares were traded. Wall Street Capital sold millions of shares, for profits that were not disclosed.
In announcing the suit, George Canellos, the director of the S.E.C.’s New York regional office, stated, “Stock promoters who make claims about companies cannot avoid liability through a ‘see no evil’ approach to the accuracy of their statements.”
But the suit itself is largely based on a different claim. The S.E.C. says Wall Street Capital misled investors when it wrote that the companies being promoted “have not approved the statements made in this release,” as well as by claiming that one source of information was “W.S.C.F. research.” The commission says it has found e-mails that show Wall Street Capital did coordinate with companies that it promoted and never did any research.
Philip Cardwell, the chief executive of Wall Street Capital, says that the S.E.C. does not understand. “In reality, W.S.C.F. is a paid marketing firm, as clearly stated in all its promotional materials,” he said in a statement, adding that the company “has never held itself out as a research analyst.” Mr. Cardwell and two others connected to the company were named as defendants in the S.E.C. action.
“We find it hypocritical,” he added, “for the S.E.C. to bring these claims against W.S.C.F. for promotion of the companies that they allege are ‘pure scams,’ all the while allowing these very same companies to continue publicly trading, and even flourishing.”
That may be a little strong. Neither PrimeGen nor the other company labeled a fraud in the S.E.C. complaint is still registered with the commission. Their shares can be traded, but brokers are not allowed to make a market in them, and the OTC Markets Web page for each company does not show quotes. Instead the pages feature a skull-and-crossbones image and label them “Caveat Emptor” stocks.
It seems unlikely that any investor who was willing to overlook — or did not bother to read — the disclosure of how Wall Street Capital was compensated would have been deterred by a disclosure that the promoter did not do any real research. But it is not at all clear that the S.E.C. would have brought the case if the firm had not mentioned its own analysis or claim that the company being promoted was not involved in the promotion.
In a way, Justice Goldberg was wrong. The securities laws do not drop the “caveat emptor” policy. If there is adequate disclosure, and you make a bad investment, that is your problem. Many years ago I talked to a frustrated state securities regulator who said there appeared to be little she could do about a Ponzi scheme that had operated in her state. An investigation showed the scheme was disclosed in materials provided to the victims.
NEW ISSUES OF CAVEAT EMPTOR
Reading the Capital Gains Research case now, only a few weeks short of the 50th anniversary of the trial court’s rejection of the S.E.C. position, serves as a reminder of how much things have changed. The judges who sided with Mr. Schwarzmann were impressed that he was recommending real companies like United Fruit and said there was no evidence he did not believe them to be good investments. He had made $19,674 by trading ahead of his customers, but the S.E.C. was not trying to force him to forfeit the money. Now it wants Wall Street Capital to forfeit its profits and pay damages as well.
The Madoff case — the largest Ponzi scheme in history — is presenting new issues of caveat emptor. The bankruptcy trustee, Irving H. Picard, concluded that the only investors who were entitled to damages were those who put in more than they took out. His theory was that “net winners” — those who took out more dollars than they invested — had profited from the fraud, even if they did not know it was going on. If Mr. Picard deems such an investor unsophisticated, he is asking for the return of net winnings paid out over a six-year period before the fraud was revealed.
But Fred Wilpon, the owner of the New York Mets and a longtime friend of Mr. Madoff, is being asked for much more. The trustee says that Mr. Wilpon and his associates took out $163 million in net winnings over the six-year period, but he also wants the $132 million in net winnings from earlier years. And to top it off, the trustee argues that because Mr. Wilpon ignored numerous “red flags” that at a minimum should have led him to investigate if Mr. Madoff was legitimate, he and his associates should pay back all the money they invested with Mr, Madoff. The suit does not spell out just how much that is, but indicates it is about $700 million, bringing the total being sought to around $1 billion.
The trustee cites no evidence that Mr. Wilpon or his associates actually knew Mr. Madoff was a fraud, but concludes that they should have known. And if they should have known, they can be treated as if they did know, and that means they acted “with actual intent to hinder, delay or defraud creditors.”
That, surely, is the ultimate in caveat emptor.