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Did The FBI Violate The California Securities Laws (CSL)?

Earlier this week, the Securities and Exchange Commission announced that it had charged a penny stock promoter in the San Diego area with fraudulently arranging the purchase of $2.5 million worth of shares in a penny stock company in an attempt to generate the false appearance of market interest and induce other investors to purchase the stock.   According to the SEC’s complaint, the hapless defendant thought he was paying a “businessman” to make purchases of the company’s shares through a network of registered representatives.  It turns out that the “businessman” was in fact an undercover FBI agent.  The complaint further alleges that the businessman (G-Man) actually participated in a “test run” in which he bought a total of 135,000 shares in one week.  Those purchases represented approximately 32% of the company’s trading volume during that week.

I was surprised that the FBI actually made such substantial purchases because those purchases may have affected the market for the company’s shares and caused others to buy shares as well.  Thus, this doesn’t appear to be case in which law enforcement simply surveilled a potential violator (e.g., by wiretapping).  Nor does this appear to be case in which law enforcement facilitated a crime (e.g., by providing ersatz drugs).  This appears to be case in which law enforcement actually participated in a criminal activity (i.e., by making actual purchases on behalf of the target)

Law enforcement participation in criminal activity raises a number of concerns.  It may, for example, actually frustrate enforcement by creating defenses such as entrapment or constitutional claims.  Participation in a crime may also actually result in more victims (as may have happened here).  U.C. Davis Law Professor Elizabeth E. Joh explores the problem of law enforcement participation in criminal activity in Breaking the Law to Enforce It: Undercover Police Participation in Crime, 62 STANFORD LAW REVIEW 155 (2009).

Section 25400(b) of the California Corporations Code declares that it is unlawful to effect, alone or with one or more other persons, a series of transactions in any security creating actual or apparent active trading in that security or raising or depressing the price of that security, for the purpose of inducing the purchase or sale of that security by others.   Even if the FBI didn’t have that purpose, its actions may fall under Section 25403 which provides that any person that knowingly provides substantial assistance to another person in violation of any provision of the Corporate Securities Law is deemed to be in violation of that provision to the same extent as the person to whom the assistance was provided.  This leaves the question of whether the FBI is a “person”.   Section 25013 defines “person” to include a government or a political subdivision of a government.

Criminal law is not my field but I certainly don’t expect to see any prosecutions of the FBI or the agent(s) involved.  This case, however, does raise interesting questions about the extent to which those who enforce the securities law can become involved in the crimes that they are investigating.

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About this Author

Keith Paul Bishop, Corporate Transactions Lawyer, finance securities attorney, Allen Matkins Law Firm

Keith Paul Bishop is a partner in Allen Matkins' Corporate and Securities practice group, and works out of the Orange County office. He represents clients in a wide range of corporate transactions, including public and private securities offerings of debt and equity, mergers and acquisitions, proxy contests and tender offers, corporate governance matters and federal and state securities laws (including the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act), investment adviser, financial services regulation, and California administrative law. He regularly advises clients...