Securities and Exchange Commission v. McGinn, Smith & Co, Inc. et al

Filing 1043

SUMMARY ORDER - That, upon the third motion of William J. Brown, asReceiver, for an order disallowing certain claims (Dkt. No. 984); and noticeof the motion having been given to the Securities and ExchangeCommission, each of the brokers listed on Ex hibit A to the motion (Dkt. No.984, Attach. 2), Kathleen Lex, and Kimellen Lex, by first class mail, and allparties who have filed a Notice of Appearance in this action by ECF, andall creditors of the McGinn, Smith entities and other parties in inter est viathe Receiver's website, which notice is deemed good and sufficient notice;and the court having deemed that sufficient cause exists, the motion isGRANTED. That each of the claims listed on Exhibit A to the motion(Dkt. No. 984, Attach. 2) i s disallowed; and the rights of the Receiver toobject on any other basis to the claims of all investors or claimants isexpressly preserved. That Rabinovich's request for redaction (Dkt. No. 1040) is DENIED. Signed by Senior Judge Gary L. Sharpe on 3/6/2019. (Copy served via regular mail)(jel, )

UNITED STATES DISTRICT COURT
NORTHERN DISTRICT OF NEW YORK
________________________________
SECURITIES AND EXCHANGE
COMMISSION,
Plaintiff,

1:10-cv-457
(GLS/CFH)

v.
MCGINN, SMITH & CO., INC.
et al.,
Defendants.
________________________________
SUMMARY ORDER
Pending is the third motion of William J. Brown, as Receiver,
(hereinafter “the Receiver”), for an order disallowing certain claims. (Dkt.
No. 984.) For the reasons below, the motion is granted.
Frank H. Chiappone, William F. Lex, and Philip S. Rabinovich,
(hereinafter “the brokers”), were registered representatives of defendant
McGinn, Smith & Co., Inc., (hereinafter “MS & Co.”). (Dkt. No. 985 at 1.)1
By way of the pending motion, the Receiver seeks an order disallowing or

1

The court assumes the parties’ familiarity with the facts of this case
and recites only those relevant for purposes of the instant motion.

equitably subordinating the brokers’ claims. (Id. at 1-2.)2 As discussed
below, the Receiver later filed a supplement to his original motion. (Dkt.
No. 1032). Before it was supplemented, the Receiver’s motion was
originally premised on factual findings made against the brokers in a
decision by an Administrative Law Judge (ALJ) in a Securities and
Exchange Commission (SEC) administrative proceeding. (Dkt. No. 985 at
1, 3-9.) The gist of the Receiver’s argument was that “[the brokers] should
not be permitted to share in investor recoveries after recklessly selling MS
& Co. offerings to innocent investors in complete disregard of their duty
owed to their customers.” (Id. at 2.)
In the face of the Receiver’s motion, only Chiappone filed a response

2

The Receiver also seeks to disallow (or, in the alternative,
equitably subordinate) the claims transferred to Lex’s wife, Kathleen Lex.
(Dkt. No. 985 at 2, 11, 15-16.) “The Receiver is seeking disallowance, or
equitable subordination, of Ms. Lex’s claims along with Lex’s claims
because the investment registers show that these investments were
originally made by Lex and Ms. Lex as joint investors.” (Id. at 11.)
Kimellen Lex, whose relationship with Lex is not specified by the Receiver,
also holds a joint claim with Lex, (id. at 17 n.4), and the Receiver seeks to
disallow that joint claim, (Dkt. No. 984, Attach. 2 at 1). Notably, both
Kathleen Lex and Kimellen Lex received notice and time to respond, (Dkt.
No. 985 at 17 n.4; Id., Attach. 9 at 1, 3), and did not.
2

in opposition. (Dkt. No. 995.)3 Chiappone’s arguments concerned the
ALJ’s decision. (Id. at 2-11.) That is, he argued that the decision was on
appeal to the SEC Commissioners, (id. at 2), and could be appealed to the
Second Circuit, (id. at 11); the decision might be mooted by a
Constitutional issue then before the Supreme Court, (id. at 2-3); and the
decision was erroneous, (id. at 3-10). In a nutshell, Chiappone argued that
he “was innocent of any unlawful conduct[] and . . . is entitled to the benefit
of the doubt until all appeals are exhausted.” (Id. at 11.)
As foreshadowed by Chiappone’s argument, on June 21, 2018, the
Supreme Court decided Lucia v. Sec. & Exch. Comm’n, 138 S. Ct. 2044
(2018), which held that SEC ALJs were subject to the Appointments
Clause, and thus any defendant in an SEC proceeding who was tried
before an ALJ not properly appointed was entitled to a new hearing, id. at
3

In a letter dated February 26, 2019, Rabinovich responded to the
Receiver’s supplement. (Dkt. No. 1040.) Rabinovich states that he “did
not . . . and do[es] not now, oppose the relief that the Receiver s[eeks].”
(Id. at 1.) Instead, Rabinovich “ask[s] that the [c]ourt direct the SEC to
redact any references to individual investors that are contained within the
numerous exhibits attached to its unnecessary filing.” (Id. at 4.)
Rabinovich feels that the “filings by the Receiver and the SEC, and in
particular their references to [him], are, most charitably put, unnecessary
and inaccurate.” (Id.) However, other than disagreeing with what the
Receiver and the SEC filed, he offers no basis for redaction, and the court
denies the request.
3

2055. Accordingly, on October 1, 2018, the SEC remanded the
administrative proceeding against the brokers for reassignment to a new
ALJ. (Dkt. No. 1032 at 5.) On December 21, 2018, the brokers and the
SEC entered into an Order, (id., Attach. 1 (hereinafter “the SEC Order”)),
which stated that the brokers violated Sections 17(a)(2) and 17(a)(3) of the
Securities Act, (Dkt. No. 1032 at 5 (citing the SEC Order at 5)).
On January 29, 2019, the Receiver filed a supplement to the pending
motion to apprise the court of these developments. (Dkt. No. 1032.) The
Receiver maintains that the brokers’ claims should be disallowed or
equitably subordinated based on the SEC Order, which contains findings
“with regard to the [b]rokers’ conduct [that] are similar to the [finding]s in
the [ALJ’s decision]—numerous red flags and ignoring the duty to
investigate.” (Id. at 7 (internal marks altered).) Chiappone did not file a
response to the Receiver’s supplement. The SEC filed a brief in support of
the Receiver’s motion on February 12, 2019. (Dkt. No. 1035.)
“[A] district court has extremely broad discretion in supervising an
equity receivership and in determining the appropriate procedures to be
used in its administration.” F.D.I.C. v. Bernstein, 786 F. Supp. 170, 177
(E.D.N.Y. 1992); see Sec. & Exch. Comm’n v. McGinn, Smith & Co., 1:104

cv-457, 2016 WL 6459795, at *2 (N.D.N.Y. Oct. 31, 2016) (“Courts have
broad authority to craft remedies for violations of the federal securities
laws[.]”) (internal quotation marks and citations omitted). “It is within a
district court’s discretion to approve a distribution plan proposed by a
receiver—and to defer to the receiver’s choices for the plan’s details—so
long as the plan is ‘fair and reasonable.’” Sec. & Exch. Comm’n v.
Amerindo Inv. Advisors Inc., No. 5-CV-5231, 2016 WL 10821985, at *3
(S.D.N.Y. May 20, 2016) (quoting Sec. Exch. Comm’n v. Wang, 944 F.2d
80, 81 (2d Cir. 1991)) (internal citation omitted).
The court agrees with the Receiver that the brokers’ claims should be
disallowed because of their conduct; the brokers should not be permitted to
share in the recovery with the innocent investors who were harmed by that
conduct. (Dkt. No. 1032 at 3.) The SEC Order states that the brokers,
who “were among the top-selling brokers at MS & Co.,” “violated Section[s]
17(a)(2) and (3) of the Securities Act by negligently failing to perform
sufficient due diligence to form a reasonable basis for their
recommendations . . . to their customers.” (SEC Order at 5.) Specifically,
disclosures were made that should have caused the brokers to conduct
additional inquiries—including how customer money would be
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invested—before recommending the investments. (Id. at 6, 7.) Also, after
being informed, in January 2008, that certain investments were in default,
payments to investors would be curtailed, and the offerings would be
restructured, the brokers continued to sell investments for MS & Co.,
despite “the accumulation of red flags since . . . September 2003.” (Id. at
7.) In one instance, the brokers failed to check publicly-available
information regarding the October 2007 Firstline Trust offering, the
proceeds of which were loaned to a company that filed for bankruptcy.
(Id.) After the bankruptcy filing, the brokers continued to sell Firstline Trust
certificates. (Id.) As part of the SEC Order, Chiappone, Lex, and
Rabinovich were ordered to disgorge $23,329, $72,726, and $53,029,
respectively, which were the amounts of their commissions during the
relevant limitations period. (Id. at 8, 9.)4
District courts have discretion to exclude claimants involved in the
underlying fraudulent scheme. See Sec. & Exch. Comm’n v. Byers, 637 F.
4

The Receiver notes that the penalties imposed by the SEC Order
were reduced because a five-year statute of limitations applied, “which
resulted in a restricted amount of potential disgorgement by the [b]rokers.”
(Dkt. No. 1032 at 7; see Dkt. No. 984, Attach. 6 at 117-18 (ordering, by
ALJ’s decision, disgorgement by Chiappone, Lex, and Rabinovich of
$103,800, $335,066, and $158,542, respectively, as well as a civil money
penalty of $130,000 each).)
6

Supp. 2d 166, 184 (S.D.N.Y. 2009). In Sec. & Exch. Comm’n v. Pension
Fund of Am. L.C., 377 F. App’x 957, 963 (11th Cir. 2010), the Eleventh
Circuit upheld the rejection of a claim by a sales agent who was among
those “responsible for recruiting the investors who ultimately suffered
losses due to the [scheme]’s fraud” and received “commissions . . . derived
from the funds of investors who were victimized by the fraudulent scheme.”
In another case, a district court excluded an individual who “was more
intimately involved with [the scheme] than the vast majority of clients and
[whose] activities extended to marketing and solicitation on [the scheme]’s
behalf.” Sec. & Exch. Comm’n v. Merrill Scott & Assocs., Civil No. 2:02 CV
39, 2006 WL 3813320, at *12 (D. Utah Dec. 26, 2006); see Sec. & Exch.
Comm’n v. Enterprise Tr. Co., No. 8 C 1260, 2008 WL 4534154, at *3, *7
(N.D. Ill. Oct. 7, 2008) (approving receiver’s proposal to exclude individuals
who, among other things, induced clients and violated state laws). In a
recent decision, a district court surveying the case law discerned that “it
would be inequitable to permit a person whose active misconduct or
unlawful activity resulted in harm to investors to recover through a
distribution.” Sec. & Exch. Comm’n v. Bivona, Case No. 16-cv-1386, 2017
WL 4022485, at *13 (N.D. Cal. Sept. 13, 2017) (internal citations omitted).
7

In this case, the brokers’ violations of the Securities Act—ignoring
numerous red flags and failing their customers on their way to becoming
some of the top-selling brokers at MS & Co., (SEC Order at 5, 6-7, 8,
9)—are sufficiently similar to the misconduct in the cases above to merit
approving the Receiver’s recommendation of disallowance. Moreover,
after responding to the Receiver’s initial motion and focusing on the ALJ’s
decision, (Dkt. No. 995), Chiappone did not respond to the Receiver’s
supplement. The court is left with the Receiver’s well-reasoned arguments,
which no longer rely on the ALJ’s decision that Chiappone found fault
with,5 (Dkt. No. 1032 at 5-8), as well as the SEC’s similar arguments in
support of disallowance, (Dkt. No. 1035 at 1-7)6; cf. Byers, 637 F. Supp. 2d
at 175 (“The SEC’s judgment is entitled to deference from this [c]ourt.”)
5

Chiappone also argued that “[n]o proof was submitted and no
finding was made that [he] knew of the fraud.” (Dkt. No. 995 at 3.) But
Chiappone fails to demonstrate why that should be dispositive, especially
in light of case law to the contrary. See Pension Fund, 377 F. App’x at
962 (reasoning argument by excluded individual that “he did not
personally commit fraud . . . misses the mark”); Bivona, 2017 WL
4022485, at *13 (“[C]ourts have approved the exclusion of
individuals . . . even when the claimant did not knowingly engage in
unlawful, wrongful, or criminal conduct.”).
6

The SEC does not request equitable subordination in the
alternative; it argues that the brokers “do not deserve any of the funds that
the Receiver has gathered for the benefit of victims.” (Dkt. No. 1035 at 2.)
8

(internal citation omitted). In short, the Receiver’s proposed disallowance
is fair and reasonable. Cf. Amerindo Inv. Advisors Inc., 2016 WL
10821985, at *3; Byers, 637 F. Supp. 2d at 184.
Accordingly, it is hereby
ORDERED that, upon the third motion of William J. Brown, as
Receiver, for an order disallowing certain claims (Dkt. No. 984); and notice
of the motion having been given to the Securities and Exchange
Commission, each of the brokers listed on Exhibit A to the motion (Dkt. No.
984, Attach. 2), Kathleen Lex, and Kimellen Lex, by first class mail, and all
parties who have filed a Notice of Appearance in this action by ECF, and
all creditors of the McGinn, Smith entities and other parties in interest via
the Receiver’s website, which notice is deemed good and sufficient notice;
and the court having deemed that sufficient cause exists, the motion is
GRANTED; and it is further
ORDERED that each of the claims listed on Exhibit A to the motion
(Dkt. No. 984, Attach. 2) is disallowed; and the rights of the Receiver to
object on any other basis to the claims of all investors or claimants is
expressly preserved; and it is further
ORDERED that Rabinovich’s request for redaction (Dkt. No. 1040) is
9

DENIED; and it is further
ORDERED that the Clerk provide a copy of this Summary Order to
the parties.
IT IS SO ORDERED.
March 6, 2019
Albany, New York

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