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Thomas O. Gorman,
Dorsey and Whitney LLP
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    This Week In Securities Litigation (Week ending August 28, 2014)

    August 27, 2014

    In the roll-up to the Labor Day weekend, the SEC issued new rules regarding asset backed securities and credit rating agencies. The Commission also announced a new pilot program on tick size.

    SEC Enforcement brought four actions this week. One involved repeated insider trading by an investor relations executive and parallels a criminal action; another focused on financial fraud; and two others concerned investment fund fraud and undisclosed conflicts by an investment adviser.

    SEC

    Rules: The SEC announced on August 27, 2014 the adoption of reform rules regarding asset-backed securities (here).

    Rules: The SEC announced on August 27, 2014 the adoption of reform rules regarding credit rating agencies (here).

    Trading: The Commission announced on August 26, 2014 a pilot plan to assess stock market tick size impact for smaller companies (here).

    SEC Enforcement –Filed and Settled Actions

    Statistics: This week the Commission filed 2 civil injunctive actions and 2 administrative proceedings (excluding 12j and tag-along proceedings).

    Insider trading: SEC v. Lucarelli, Civil Action No. 14-cv-6933 (S.D.N.Y. Filed August 26, 2014). Michael Lucarelli was the Director of Market Intelligence at Lippert/Heilshorn & Associates, an investor relations firm. He began work at the firm in August 2012 after years at another firm. His role was to develop new client relationships. In that role he did not routinely review drafts of firm press releases. Beginning in August 2013, and continuing through at least August 2014, Mr. Lucarelli is alleged to have used his position at the firm to obtain inside information regarding at least 20 clients. In each instance he traded in advance of a corporate event, purchasing securities and making illicit profits. Overall he is alleged to have had profits of almost $1 million by the SEC.

    On July 24, 2014 the FBI obtained a search warrant for Mr. Lucarelli’s office. During the search, which was conducted without his knowledge, a locked briefcase was seized. Inside was a draft press release for firm client TREX Company. The press release contained the second quarter 2014 financial results. The search of his office was completed the next day as Mr. Lucarelli began purchasing shares of TREX. From July 25, 2014 through August 1, 2014 Mr. Lucareli acquired a net position of 37, 400 shares of TREX. Within two hours of the earnings announcement Mr. Lucarelli sold 35,058 of the 37,400 shares he had purchased, yielding profits of almost $90,000. The SEC’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 14(e). See Lit. Rel. No. 23074 (August 26, 2014). The Manhattan U.S. Attorney’s Office filed parallel criminal charges. U.S. v. Lucarelli (S.D.N.Y.). The criminal complaint alleges 13 counts of securities fraud based on 12 instances of insider trading and illicit trading profits of over $538.000. Both cases are pending.

    Conflicts: In the Matter of Edgar R. Page, Adm. Proc. File No. 3-16037 (August 26, 2014) is a proceeding which names as Respondents, Mr. Page, the sole owner and principal of registered investment adviser PageOne Financial, Inc., also a Respondent. The Order alleges that beginning in early 2009, and continuing for about the next two years, the Respondents concealed significant conflicts from the advisory clients. Specifically, those clients were not informed that one of the fund mangers was acquiring a significant stake in PageOne, that Mr. Page had agreed to raise a substantial sum for the private funds and that the fund manager was paying for the acquisition through installment payments which were in part tied to Respondents’ ability to direct client money to the private funds. In addition, misleading disclosures regarding the payments were made in PageOne’s Forms ADV. The Order alleges violations of Advisers Act Sections 206(1), (2) and 207. The proceeding will be set for hearing.

    Investment fund fraud: SEC v. Villarreal, Civil Action No. 14-cv-01891 (N.D. Ohio Filed August 26, 2014) names as a defendant Oscar Villarreal. The complaint alleges two fraudulent offering schemes. The first, known as Fund III, raised about $9.2 million from 46 investors beginning in March 2009 and continuing through the end of the next year. Investors were told their funds would be invested in private equity investments in Mexico. Instead portions were used and lost through stock market trading while other funds were misappropriated by Mr. Villarreal. The second, Standard Asset Management Fund I or SAM Fund, raised about $9 million from 11 investors based on false claims that that the funds would be invested in the Mexican stock market. In fact the funds were lost trading in the market and again portions were misappropriated. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 206(4). The case is pending. See Lit. Rel. No. 23073 (August 26, 2014).

    Financial fraud: In the Matter of AirTouch Communications, Inc., Adm. Proc. File No. 3-16033 (August 22, 2014). In addition to the firm, Hideyuki Kanakubo, the firm’s founder and former CEO, and Jerome Kaiser, its former CFO, were named as Respondents. The scheme alleged in the Order has two facets. The first involved improper revenue recognition. Specifically, in early 2012 the company developed a new product called U250. It was designed for sale to Mexico’s largest provider of landline telephone services. In July 2012 AirTouch entered into a contract with a Florida based provider of logistics and fulfillment services regarding the product under which about $1.7 million in U250 product would be held by the Florida entity. That entity would execute a Purchase Order for the equipment and an Agreement under which no product would be delivered, and no payment due, unless and until the Mexican entity actually ordered and paid for the product. The revenue from the Purchase Order was booked, however, and reflected in the Form 10-Q filed for the third quarter of the year. Second, the firm used the Purchase Order to secure a $2 million loan from a shareholder who was shown the Purchase Order but not the Agreement. In January 2013 the AirTouch board of directors initiated an internal investigation regarding the net reported revenues in the Form 10-Q for the third quarter of 2012. Although a restatement is supposed to be done, to date it has not been filed. The Order alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The proceeding will be set for hearing.

    FINRA

    Best execution: The regulator fined Citigroup Global Markets, Inc. $1.85 million and ordered that restitution of $638,000 be paid. The sanctions were imposed because the firm failed to ensure that customers received best execution. Specifically, for certain securities FINRA determined that the firm used a manual pricing methodology that did not appropriately incorporate the National Best Bid and Offer. The firm priced more than 7,200 customer transactions at prices less than NBBO because the firm’s proprietary BondsDirect order execution system used a faulty pricing logic. The regulator also found that Citigroup’s supervisory system and written supervisory procedures for best execution for the specific securities involved here were deficient.

    SEC – USAO Charge IR Executive With Insider Trading

    August 26, 2014

    The SEC may be developing theme based insider trading cases. In recent weeks the agency brought two insider trading actions centered on golfing friends. SEC v. O’Neill, Civil Action No. 1:14-cv-13381 (D. Mass. Filed August 18, 2014); SEC v. McPhail, Civil Action No. 1:14-cv-12985 (D. Mass. Filed July 11, 2014).

    Now it is investor relations professionals. Last month the Commission brought an insider trading case against one investor relations executive. SEC v. McGrath, 14-cv-3483 (S.D.N.Y. Filed July 22, 2014). A second investor relations executive was named in an insider trading case by the agency yesterday. SEC v. Lucarelli, Civil Action No. 14-cv-6933 (S.D.N.Y. Filed August 26, 2014). The Manhattan U.S. Attorney’s Office filed parallel criminal charges. U.S. v. Lucarelli (S.D.N.Y.).

    Michael Lucarelli was the Director of Market Intelligence at Lippert/Heilshorn & Associates, an investor relations firm. He began work at the firm in August 2012. Previously, he had been employed at another investor relations firm for a number of years.

    When he accepted his new position, Mr. Lucarelli was furnished with the firm’s Code of Conduct. It prohibited insider trading. Mr. Lucarelli acknowledged obtaining the Code in an e-mail to the firm. The firm routinely had material non-public information regarding clients. Mr. Lucarelli’s role was to develop new client relationships for the firm. In that role he did not routinely review drafts of firm press releases.

    In January 2008 the executive opened a brokerage account. At the time Mr. Lucarelli did not disclose that he worked for an investor relations firm. Rather, he told the brokerage firm that he was self-employed. He repeated this procedure in subsequent years when he moved his account to other brokerage firms.

    Beginning in August 2013 and continuing through at least August 2014, Mr. Lucarelli is alleged to have used his position at the firm to obtain inside information regarding at least 20 clients. In each instance he traded in advance of a corporate event, purchasing securities and making illicit profits. Overall he is alleged to have had profits of almost $1 million by the SEC. The criminal complaint, based on 12 instances of insider trading, alleges illicit trading profits of over $538.000.

    On July 24, 2014 the FBI obtained a search warrant for Mr. Lucarelli’s office at the firm. During the search, which was conducted without his knowledge, a locked briefcase was seized. Inside was a draft press release for firm client TREX Company. The press release contained the second quarter 2014 financial results for the company. The search of his office was completed the next day.

    As the search was being completed Mr. Lucarelli began purchasing shares of TREX. From July 25, 2014 through August 1, 2014 Mr. Lucareli acquired a net position of 37, 400 shares of TREX. Before the opening of the market on August 4, 2014 the firm announced its financial results. Pre-tax earnings had increased 23%. TREX also announced revenue guidance for the third fiscal quarter of 2014. It was up 27% over the comparable period in the prior year. Within two hours of the announcement Mr. Lucarelli sold 35,058 of the 37,400 shares he had purchased, yielding profits of almost $90,000.

    The SEC’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 14(e). See Lit. Rel. No. 23074 (August 26, 2014). The criminal complaint alleges 13 counts of securities fraud. Both cases are pending.

    Anti-Corruption Campaign in China—Causes of Corruption, and Hope?

    August 25, 2014

    The following guest post is the first part of an occasional series on the anti-corruption campaign in China. The authors are resident in the Hong Kong office of Dorsey & Whitney LLP. SECactions welcomes submissions from other interested authors. This article originally appeared in the Financial Fraud Law Report.

    By David Richardson and Alesya Tepikina*

    This article focuses on the social practices which allow corruption to thrive in China, and on economic reforms (and a developing legal system) which could reign in such corruption.

    “I have seen corruption boil and bubble Till it o’er-run the stew.”—William Shakespeare, MEASURE FOR MEASURE

    Introduction

    Corruption in the People’s Republic of China presents a major administrative and financial burden on businesses operating in China and creates an unfavorable business environment (by undermining the operational efficiency of businesses and raising the costs and risks associated with doing business in China). 1 As noted by some researchers, corruption is so widespread in China that it has become a norm, an unwritten law, and a way of living. 2 Corruption threatens the vitality and international credibility of China’s emerging new economy. 3 Out of 2,700 firms surveyed from November 2011 through March 2013, 19.2 percent reported that they were expected to give gifts to obtain import licenses, 18.8 percent said they were expected to give gifts to obtain construction permits, 10.9 percent reported they were expected to give gifts to tax inspectors and 10.7 percent said they were expected to give gifts to public officials “to get things done.” 4 Bribery incidence (i.e., a percentage of firms that experienced at least one bribe payment request) was 11.6 percent and bribery depth (i.e., a percentage of public transactions where a gift or informal payment was requested) was 9.9 percent. 5

    Since President Xi Jinping announced a crackdown on corruption among government officials in China in November 2012, multiple anti-graft and anti-extravagance regulations have been passed by government agencies at the central and local levels. The regulations allowed the Xi administration to single out officials for punishment, starting at the local level and moving up the ranks of party hierarchy.This article focuses on the social practices which allow corruption to thrive in China, and on economic reforms (and a developing legal system) which could reign in such corruption.

    Extent of Corruption

    In 2013, the Transparency International’s Corruption Perceptions Index (the “Index”), which ranks countries based on the perception of corruption in their public sector, ranked China at 40, 6 placing it in the 80th place out of 175 countries surveyed, on a par with Greece. China was ranked less corrupt than El Salvador, Jamaica, Panama, Russia, and Peru, but more corrupt than Brazil and more developed countries. 7 Over the past 14 years, China’s rank remained at the lower range of the Index. For example, in 2008, China was ranked at 3.6 (on a scale of 0–10 used by the Index at that time), placing it in the 70th place out of 163 countries surveyed, and in 2000, China was ranked at 3.1, placing it in the 63rd place out of 90 countries surveyed. China historically ranked less corrupt than India, Russia, and Venezuela, but more corrupt than Zambia, Colombia, Mexico, Ghana, and South Korea.

    As elsewhere, power over transactions and wealth in China appears to lead inevitably to corruption and corrupting behavior, or, in the words of Lord Acton, “power tends to corrupt and absolute power corrupts absolutely.” 8 These words seem to apply perfectly to China, where the Communist Party has had a monopolistic power on politics and economics of the country for a prolonged period of time. 9 In China, as is often the case elsewhere, corruption is also a consequence of deeper stresses and changes. Underlying corruption is a growing tension between new policies and economic realities on the one hand, and traditional values, customs and established political system on the other, in the context of a political and institutional framework poorly-suited to handle such tension.

    Understanding the characteristics and reasons underlying corruption in traditionalChina is crucial to comprehending the nature of the relationship between politics and economics in contemporary China, and to envisioning the future direction of reforms. As described by some researchers, “post-reform corruption is a complex mixture of universal, transitional socialist and unique Chinese characteristics in its origins, consequences, as well as definitions.” 10

    Definition and Characteristics of Corruption

    One of the most general definitions of corruption, which seems to apply to China as well, describes it as ultimately “the use of public office for private gain.” 11 It is also commonly understood as “behavior which deviates from the formal duties of a public role because of private-regarding (personal, close family, private clique) pecuniary or status gains; or violates rules against the exercise of certain types of private regarding behavior.” 12 Corruption can be characterized by the following features:

    • Power exploited for personal gain which includes monetary and nonmonetary rewards;

    • An implicit contract concluded via a specific transaction, i.e. the transference of property rights, which because of its illegality is not subject to any officially legitimized institutional executive or sanctioning instance; and

    • At least two economic subjects interacting in the above transference of property right; this explicitly excludes the theft or embezzlement of state property as well as influencing of the political process to preserve power.

    Guanxi Networks

    Corruption has deep roots and a long history in China. To understand the phenomenon of corruption as it applies to contemporary China, the historical role of patron-client and instrumental-personal ties in traditional China must first be analyzed.

    The spread of corruption in traditional China is often connected to the Confucian concept of renzhi, or “government of the people,” as opposed to “government of thelaw.” Chinese social behavior leading to corruption can be partly understood in terms of the hierarchical roles taught by Confucianism. 13 These roles dictate the obligations an individual has in five cardinal relationships. Among them is the filial responsibility of son toward father, which is the template for other hierarchical relationships in the system of Confucian ethics, such as that of subject-to-emperor and student-to-teacher. 14 This hierarchical system of ethics was transplanted into the workplace, where it became the basis of a pervasive “organized dependency” of society upon the communist state. 15 It evolved into an unofficial method utilized by workers to secure access to scarce goods and services (e.g., food, housing, or admission to schools) which were selectively distributed by shop officials. As benefits and resources were allocated directly by the planning bureaucracy in factories, workers relied on an informal “natural economy” of personal connections based on the exchange of gifts and favors in order to build privileged interactions with the gatekeepers who controlled them: factory officials. 16

    Traditional Confucian values also emphasize consensus, lasting authority and clearly-defined personal relationships, a unity of state and society, and a socially encompassing moral order. These values led to social and cultural practices based on the extended personal-exchange and patron-client relationships encompassed by the term guanxi, which means interpersonal connections in order to secure favors in personal relations. 17

    Guanxi networks can be seen as institutions that arose centuries ago to secure trade relations in an environment that was only insufficiently covered by the legal system. 18 An individual was able to expand his radius of economic relations, backed up by guanxi networks, to include various networks each with different resources. 19 A targeted expansion of an individual’s network to a counterparty which was regarded as useful for the pursuit of common interests could also be achieved by the giving of a gift or service. By accepting the gift or service, the counterparty obligated itself to perform an undefined reciprocal service at an unspecified time in the future. In this way, an implicit contract was concluded the fulfillment of which was linked to the particular network. 20

    Guanxi networks can also be seen as clubs that guarantee their members the enforceability of available property rights in an institutionally disorderly environment, thus lowering transaction costs. 21 To a certain extent, guanxi networks through personal connections and cooperation over a long period acted as a substitute for the market and the legal-institutional environment that supported it. 22 At a later stage, connections served as a coordinating mechanism that allowed for a more efficient allocation of shortage goods than that provided by the fissures and fault lines of the communist economy. “This pattern is the result of structural features common to all communist factories: the workers’ economic dependence on the enterprise; political shop officials over promotion, pay, direct distributions, and sociopolitical services.” 23

    Developed over centuries, guanxi networks were strongly anchored in traditional China and had an important function not only on an economic, but also on a political and social, level. They are still a factor in numerous areas in contemporary China, and virtually every Chinese person is connected to at least one guanxi network. 24 As noted by some researchers, guanxi networks stood in an antagonistic relationship to the Western system of legal rights. 25 In the West, Christianity combined with pre-existing institutions to produce clear jurisdictional lines of top-down personalized authority. In the economic sphere, this led to legal definitions of property and ownership. Chinese institutions, however, rested on relationships and not jurisdictions, on obedience to one’s own roles and not on bureaucratic command structures. “Both jurisdictional principles and the autonomous individuals are historically absent in the Chinese worldview, and thus were not incorporated in Chinese institutions. Instead, Chinese society consists of networks of people whose actions are oriented by normative social relationships.” 26

    Guanxi Networks and Economic Reforms in China

    With the advent of the “open-door policy” in China in 1978 and the subsequent reform period, guanxi networks underwent a gradual but substantial transformation from vertical relationships between officials and the rank and file to vertical relationships between officials and business. This change was brought about by the introduction of a market economy that was permitted to run in parallel with the old command economic mode. Following the implementation of the dual-track system, old central-administrative mechanisms were abandoned, often without putting in place new market-oriented substitutes capable of governing the transition. In this new hybrid system, the coexistence of guanxi networks and an emerging product
    market blurred the limits between regular economic transactions and corruption. 27 To a certain extent, guanxi networks advanced development of division of labor in the economic process and development in Chinese society over the centuries, and existed as complementary and parallel mechanisms for orderly economic interaction. In the reform period, organization of economic activities by guanxi networks regained Guanxi networks created governance structures that forced contract-honoring behavior of the transaction partners, analogous to vertical integration solutions. 29 Guanxi networks thus managed to provide an infrastructure in which the transactionpartners could safeguard themselves from the ex post opportunismof one side. For some time, guanxi networks appeared to be an efficient and transaction-cost-lowering coordination mechanism for regulating transactions in an environment characterized by high institutional uncertainty. 30

    The reforms were aimed at the dissolution of established, central-administrative orderly mechanisms and development of the legal system. However, the first contract law did not take effect until July 1982, four years after the reform period had begun. The law was still strongly bound to the old central administrative system and quickly came into contradiction with subsequent laws and decrees, but was not revised until1993. A comprehensive contract law only came into effect in October 1999. Even more problematic than this delayed enactment of laws was the poor enforcement of the existing laws mainly due to the administrative interventions and insufficient training of the officials enforcing the law. 31

    The continuing liberalization of the Chinese economy requires a developed legal system which would provide a well framed regulatory and institutional framework for regulating financial and commercial transactions, testing them against principles of anti-corruption and offering legal security at a supra-individual level beyond social relationships. Such legal system would remove uncertainty as to enforcement of contractual rights and would therefore eliminate reliance on guanxi networks to safeguard transactions. However, transaction partners would need to regard such legal
    system as performing more effectively than guanxi networks before they could view it as preferable for regulating transactions. In addition, as noted by some researchers, pressure by political decision-makers would be required in order for the legal system to displace guanxi networks. 32 Thereafter, as transaction costs for corrupt transactions would increase, guanxi networks would gradually lose importance and ultimately disappear, and incidences of corruption would decline.

    End notes

    David Richardson is a partner and Alesya Tepikina is an associate in the Corporate Department of the Hong Kong office of Dorsey & Whitney. They can be reached at richardson.david@dorsey.com and tepikina.alesya@dorsey.com, respectively.

    1 According to the Enterprise Surveys conducted by the World Bank,http://www.enterprisesurveys.org/~/media/GIAWB/EnterpriseSurveys/Documents/Profiles/English/china-2012.pdf.
    2 http://www.nytimes.com/2012/05/09/opinion/no-roads-are-straight-here.html.
    3 http://unpan1.un.org/intradoc/groups/public/documents/apcity/unpan024539.pdf.
    4 http://www.enterprisesurveys.org/~/media/GIAWB/EnterpriseSurveys/Documents/Profiles/English/china-2012.pdf; http://www.enterprisesurveys.org/Data/ExploreEconomies/2012/china#
    corruption.
    5 http://www.enterprisesurveys.org/Data/ExploreEconomies/2012/china#corruption.
    6 The Index ranks countries on a scale of 0 – 100, where 0 means that the public sector of a country is perceived as very corrupt and 100 means it is perceived as very clean.
    7 http://cpi.transparency.org/cpi2013/results/.
    8 Comment of Lord Acton (1834-1902) in a letter to Bishop Mandell Creighton (quoted after
    Bardhan, 1997), cited in http://www.icgg.org/downloads/contribution10_schramm.pdf.
    9 http://www.albertodifelice.com/essays/corruption-china.php.
    10 Sun, Yan (2001) “The Politics of Conceptualizing Corruption in Reform China,” cited in http://www.albertodifelice.com/essays/corruption-china.php.
    11 Bardhan, P. (1997) “The Role of Governance in Economic Development: A Political Economy Approach”, cited in http://wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.
    12 Ney, J.S. (1967) “Corruption and Political development: A Cost-Benefit Analysis”; Klitgaard,
    R.E. (1988) “Controlling Corruption,” cited in http://wwwuser.gwdg.de/~uwvw/downloads/
    contribution10_schramm.pdf.
    13 http://www.albertodifelice.com/essays/corruption-china.php.
    14 Hsu, F.L.K. (1953) “Americans and Chinese: Two Ways of Life,” cited in http://www.bm.ust.
    hk/mgmt/staff/papers/Bilian/OrgSci_2008_19_517.pdf.
    15 http://conferences.wcfia.harvard.edu/files/gov2126/files/johnston_hao__china_surge_
    corruption.pdf.
    16 Walder, Andrew (1986) “Clientelist Bureaucracy: The Factory Social Order,” cited in http://www.albertodifelice.com/essays/corruption-china.php.
    17 http://unpan1.un.org/intradoc/groups/public/documents/apcity/unpan024539.pdf.
    18 Carr, J.L. and Landa, J.T. (1983) “The Economics of Symbols, Clan Names, and Religion”;
    Posner, R. A. (1980) “A Theory of Primitive Society, with Special Reference to Law,” cited in

    http://wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.

    19 Krug, B. and Polos, L. (2000) “Entrepreneurs, Enterprises, and Evolution: The Case of China,” cited in http://wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.
    20 Hsing, Y.T. (1998) “Making Capitalism in China: The Taiwan Connection,” cited inhttp://wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.
    21 http://www.icgg.org/downloads/contribution10_schramm.pdf.
    22 Johnston, Michael (2001) “Corruption in China: Old Ways, New Realities and a Troubled Future,” citedinhttp://www.albertodifelice.com/essays/corruption-china.php.
    23 Walder, Andrew (1986) “Clientelist Bureaucracy: The Factory Social Order,” cited in http:// www.albertodifelice.com/essays/corruption-china.php. www.albertodifelice.com/essays/corruption-china.php.
    24 http://wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.
    25 Hamilton, G.G. (1994) “Civilizations and the Organization of Economics,” cited in http:// wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.
    26 Hamilton, G.G. (1994) “Civilizations and the Organization of Economics,” cited in http://
    wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.
    27 http://www.icgg.org/downloads/contribution10_schramm.pdf.
    28 http://www.icgg.org/downloads/contribution10_schramm.pdf.
    29 Reja, B. and Tavitie, A. (2000) “The Industrial Organization of Corruption: What is the Difference in Corruption Between Asia and Africa,” cited in http://wwwuser.gwdg.de/~uwvw/
    downloads/contribution10_schramm.pdf.
    30 http://wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.
    31 Tao, Z. and Zhu, T. (2001) “An Agency Theory of Transaction without Contract Enforcement:
    The Case of China;” Wank, D.L. (1999) “Producing Property Rights: Strategies, Networks, and
    Efficiency in Urban China’s Nonstate Firms,” cited in http://wwwuser.gwdg.de/~uwvw/downloads/ contribution10_schramm.pdf.
    32 http://wwwuser.gwdg.de/~uwvw/downloads/contribution10_schramm.pdf.

    SEC Files Financial Fraud Action

    August 24, 2014

    Financial fraud is an enforcement priority of the SEC. A financial fraud task force was formed in July 2013. Its purpose is to focus on this traditional staple of enforcement. A data analysis group was formed at the same time to give the task force a new big data type approach under which computers would aid with prospecting for fraudulent financial statement conduct. To date, few cases have been brought, although traditionally the complexity of these cases means it can take substantial amounts of time to complete the investigation.

    One case brought in this area is In the Matter of AirTouch Communications, Inc., Adm. Proc. File No. 3-16033 (August 22, 2014). In addition to the firm, Hideyuki Kanakubo, the firm’s founder and former CEO, and Jerome Kaiser, its former CFO, were named as Respondents. AirTouch develops and sells telecommunications equipment designed to integrate mobile phones into landline systems within a consumer’s home. The firm’s shares are quoted in the OTC Pinks.

    The scheme alleged in the Order has two facets. The first involved improper revenue recognition. Specifically, in early 2012 the company developed a new product called U250. It was designed for sale to Mexico’s largest provider of landline telephone services.

    In July 2012 AirTouch entered into a contract with a Florida based provider of logistics and fulfillment services regarding the product. Under the arrangement about $1.7 million in U250 product would be held by the Florida entity. That entity would execute a Purchase Order for the equipment. At the same time, however, AirTouch and the Florida firm executed an Agreement under which no product would be delivered and no payment due unless and until the Mexican entity actually ordered and paid for the product.

    In October 2012 AirTouch’s controller provided the firm’s outside independent accountant with a copy of the Purchase Order from the Florida company. The accountant was not provided with a copy of the related Agreement. Messrs. Kanakubo and Kaiser did not inform the outside accountant or the independent directors on the board about the Agreement when discussing the Purchase Order from the Florida entity. AirTouch did not receive any payment from the Florida company.

    On November 14, 2012 the firm voluntarily filed a Form 10-Q for the third quarter of the year. It reported net revenues of $1,031,747, recognizing revenue from the Purchase Order. If that revenue had not been recognized, the firm would not have had positive revenue. Yet recognizing the revenue under the circumstances here was contrary to the firm’s stated revenue recognition policies and GAAP.

    Second, the firm used the Purchase Order to secure a $2 million loan from a shareholder. During 2012 Messrs. Kanakubo and Kaiser solicited a short term bridge loan from an AirTouch Shareholder. That Shareholder was told in an October 2012 e-mail about the shipment of product under the Purchase Order to the Florida firm. The Shareholder was also furnished with a copy of the Purchase Order. The Shareholder was not furnished with a copy of the related Agreement. The firm and Shareholder entered into an agreement under which $2 million was loaned to AirTouch in return for a promissory note and stock options.

    Subsequently, Mr. Kanakubo approved a $15,000 bonus to Mr. Kaiser for his work on raising capital. At the same time he awarded himself a bonus in the same amount in connection with unused vacation time.

    In January 2013 the AirTouch board of directors initiated an internal investigation regarding the net reported revenues in the Form 10-Q for the third quarter of 2012. At the time Mr. Kaiser furnished the chairman of the audit committee with the Purchase Order but not the related Agreement. When the board of directors finally received the Agreement a restatement of the third quarter was directed. In February 2013 the firm filed a Form 8-K announcing the errors in revenue recognition and stating its intention to file an amended Form 10-Q. That filing has not been made.

    The Order alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The proceeding will be set for hearing.

    This Week In Securities Litigation (Week ending August 22, 2014)

    August 21, 2014

    The Second Circuit upheld SEC Rule 10b-5-2 which defines certain types of relationships as the predicate for insider trading. In reaching its conclusion the Court rejected an argument that an insider trading claim must be based on a breach of fiduciary duty.

    This week the Commission brought a second action against Bank of America tied to the market crisis. This action, based on the sale of residential mortgages and RMBS years ago, was resolved with admissions, a cease and desist order and the payment of a penalty. The action was tied to the overall DOJ settlement with the bank. The agency also brought another insider trading case tied to golf; an offering fraud action; a pump and dump manipulation case; and a proceeding based on the failure to implement procedures to protect confidential information.

    SEC

    Remarks: Rick Fleming, Investor Advocate, addressed the 38th Annual Southwest Securities Conference, Dallas, Texas (August 19, 2014). The remarks focused on the functions of the Office and user fees (here).

    Exam initiative: The Office of Compliance Inspections and Examinations announced that it is launching an examination initiative directed at newly regulated municipal advisors (here).

    SEC Enforcement – Litigated Actions

    Remedies: SEC v. Nocella, Case No. 4:12-cv-1051 (S.D. Tx. Opinion August 11, 2014) is a financial fraud action against two former bank officers, CEO Anthony Nocella and CFO J. Russell McCann. The complaint centered on what was claimed to be the efforts of Messrs. Nocella and McCann to prop-up Franklin Bank Corp., a Texas based savings and loan holding company. By the second quarter of 2007 the loan portfolio of the financial institution began to deteriorate as the financial crisis unraveled. Messrs. Nocella and McCann crafted three plans to improve the appearance of the loan portfolio and thus the operating results of the bank: Fresh Start, Strathmore modifications and Great News. Each program essentially brought the loans current through various devices which were either inconsistent with bank practice or the appropriate accounting. The complaint alleged violations of Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). It requested a permanent injunction, disgorgement, prejudgment interest, civil penalties, officer and director bars and repayment under SOX 304.

    The Court considered the question of remedies against Messrs. Nocell and McCann in ruling on a summary judgment motion. After reviewing the facts regarding the loan programs, the Court turned to the question of whether an officer or director bar should be imposed. Here the violations were not egregious, the Court found. Neither officer profited and both are first time offenders. While they were senior officers of the bank, many at the institution participated in the programs which were disclosed to the FDIC. Likewise, neither defendant acted with the intention to defraud the shareholders. When the FDIC disagreed with the Strathmore loan classifications, the pertinent corrections were made. Indeed, the acts involved here appear to stem from “a good-faith attempt to manage a floundering bank during a recession. Finally, neither defendant is in a position to violate the securities laws in the future. Mr. Nocella retired and Mr. McCann works for a private bank.

    Based on these findings the Court declined to enter an officer and director bar as to either defendant concluding: “This court recognizes that it is wrong that Franklin Bank Corporation improperly accounted for modified mortgages under their management. It is abusive to seek a permanent bar against two executives who were working for a troubled company in a troubled time without adequate evidence that they were responsible for the improper accounting.”

    SEC Enforcement –Filed and Settled Actions

    Statistics: This week the Commission filed 3 civil injunctive actions and 2 administrative proceedings (excluding 12j and tag-along proceedings).

    Market crisis: In the Matter of Bank of America Corporation, Adm. Proc. File No. 3-16028 (August 21, 2014) is the second action brought by the Commission against the bank tied to the market crisis. Between 2004 and 2008 the bank and certain acquired entities sold about $2.1 trillion of mortgage loans and RMBS. About $1.1 of those were mortgage loans sold to GSEs, primarily Fannie Mae and Freddie Mac. In connection with those transactions various representations were made. If there was a breach of those representation the issue would have to be resolved and could result in a recession of the transaction. When Fannie Mae went into conservatorship it adopted a more aggressive policy regarding how breach claims were handled. That resulted in a rise in the number of contested or impasse situations. The bank failed to disclose this known uncertainty. In addition, through an acquisition the Bank acquired about $160 million of RMBS with monoline insurance. The bank did not create a reserve. The bank thus failed to disclose these known uncertainties in the MD&A section of its Forms 10Q for the second and third quarters of 2009 which were incorporated by reference into a registration statement. The Order alleges violations of Exchange Act Section 13(a) along with Rules 12b-20 and 13a-13. To resolve the proceeding the bank made certain admissions regarding the transactions and stated that its conduct violated the federal securities laws. The bank also agreed to the entry of a cease and desist order based on the Section and Rules cited. In addition, Bank of America will pay a civil penalty of $20 million which will be deemed satisfied by its payment in accord with the terms of a settlement with DOJ.

    Procedures: In the Matter of Monness, Crespi, Hardt & Co., Inc., Adm. Proc. File No. 3-16025 (August 20, 2014) is a proceeding which names as a Respondent the registered broker dealer. Over a period of six years, beginning in 2006, the firm failed to properly implement portions of its procedures regarding confidential information. Specifically, it failed to require employees to submit reports of their securities transactions and to maintain a restricted list. It also did not adopt policies for certain of its programs which posed the risk of disclosure regarding material, nonpublic information about up coming analyst reports. The Order alleges violations of Exchange Act Section 15(g). The firm adopted the necessary procedures when notified by the staff. It resolved the proceeding by consenting to the entry of a cease and desist order based on the cited Section as well as a censure. The firm will pay a civil penalty of $150,000.

    Insider trading: SEC v. O’Neill, Civil Action No. 1:14-cv-13381 (D. Mass. Filed August 18, 2014). The action names as defendants Patrick O’Neill and Robert Bray. It focuses on the June 29, 2010 announcement that Wainwright Bank & Trust Company was going to be purchased by Eastern Bank Corporation. Mr. O’Neill was the Eastern Bank Senior Vice-President and Senior Credit Officer. Mr. Bray was an affiliate of R&B Construction Company. When Mr. O’Neill joined Eastern Bank in early 2010 he read and acknowledged the insider trading policy of the bank. A few days later the bank asked him to also execute a confidentiality agreement which stated in part that Eastern was involved in a possible transaction regarding Wainwright and that he would likely receive confidential information. It also noted that he likely would conduct due diligence on the proposed deal and that the information he would obtain was “inside information” under the applicable securities laws. Subsequently, Mr. O’Neil conducted due diligence on Wainwright’s loan portfolios. That work was completed by June 28, 2010. Messrs. O’Neill and Bray had been friends for many years. Both were golfers and members of the same local country club. Both socialized at the country club bar. On one or more days between May 20 and June 13 the two men were together, according to the complaint. On Monday June 14, 2010 Mr. Bray sold the shares of three other stocks in his brokerage account for total proceeds of over $261,000. He used the proceeds to purchase Wainwright shares. Over a period of days beginning on June 14 he accumulated 31,000 shares of Wainwright stock at a cost of over $288,000. When the deal was announced the share price spiked up 94% giving Mr. Bray profits of almost $300,000. The Commission’s complaint alleges violations of Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 230790 (August 18, 2014).

    Offering fraud: SEC v. Gamer, Civil Action No. 1:14-cv-02650 (N.D. Ga. Filed August 15, 2014). The defendants are Heidi Ann Gamer and her two controlled entities, Gamer Economic Systems, LLC and Gamer Media Partners. Interests in each entity were marketed using claims that interactive software and technology, including applications for smartphones, would be developed. Investors were told about a product called “StoryMap.” This app supposedly permitted television viewers to look up the episodic history of a show and purchase items seen on the set. In some sales pitches potential investors were told of a $100,000 contract with Dartmouth College and a deal with the Atlanta Falcons. Between August 2012 and May 2013 Ms. Gamer sold interest to 27 investors, raising over $370,000 for interests in GMP. Over $700,000 was raised from marketing both entities. In fact the money was not used as represented and much of it was diverted to personal use. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 23071 (August 19, 2014).

    Manipulation: SEC v. Farmer, Civil Action No. 4:14-cv-02345 (S.D. Tx. Filed August 14, 2014) is an action against Andrew Farmer, Charles Grob, Jr., Carolyn Austin, Baldemar Rios and Chimera Energy Corporation. The complaint alleges that from August 2011 through November 2012 the defendants engaged in a pump and dump manipulation scheme. Specifically, Mr. Farm first conducted an IPO for Chimera, a shell company, and gained control of its outstanding stock. Then a series of false press releases were issued touting the company as having a revolutionary new technology that supposedly enabled production of shale oil and gas without the perceived environmental impact of hydraulic fracturing. As the stock price increased Mr. Farmer sold his shares, reaping at least $4.58 million in profits. The complaint alleges violations of Securities Act Sections 5(a) and (c) and 17(a) and Exchange Act Sections 10(b) and 15(d). The case is in litigation. See Lit. Rel. No. 23072 (August 21, 2014).

    Court of appeals

    Insider trading: U.S. v. McGee, No. 13-3183 (3rd Cir. Decided August 14, 2014) the Court rejected a claim that the SEC exceeded its authority when enacting Rule 10b5-2 because it did not require a fiduciary duty. Timothy McGee was convicted by a jury of insider trading. That conviction is based on the misappropriation theory. Between June and July 2008 he obtained material non-public information regarding the then pending sale of Philadelphia Consolidated Holding Corporation or PHLY from Christopher Maguire, an insider at the company. Mr. McGee then borrowed about $226,000 to purchase 10,750 shares of PHLY. After the deal announcement he had trading profits of $292,128. A jury convicted him of insider trading based in part on Rule 10b5-2.

    On appeal Mr. McGee challenged Rule 10b5-2(2), arguing that it exceeds the SEC’s authority since a fiduciary duty is required. Turing to the question of whether the SEC is entitled to difference under Chevron, the Court first sought to determine if Section 10(b) is ambiguous on the precise question. That Section, the Court concluded, is ambiguous since it does not define “deceptive device” and, in fact, does not mention insider trading much less define the necessary type of relationship.

    The critical question then becomes whether judicial precedent foreclosed the action taken by the SEC. Mr. McGee claimed that Supreme Court precedent precluded the action taken by the SEC with respect to the Rule. The Court disagreed, however, noting that O’Hagan and other decisions by the Supreme Court in this area do not specifically define the type of relationship necessary. While those decisions frequently discuss fiduciary relationships, they do not require such a relationship.

    Since there is no specific judicial precedent defining the necessary relationship, the question is if the SEC’s construction is one it permissibly could have adopted. Considering the purpose of the Act the Court determined that “Rule 10b5-2(2) is based on a permissible reading of ‘deceptive device[s]’” under Section 10(b) of the Exchange Act. The Court concluded by noting that “Although we are not without reservations concerning the breath of misappropriation under Rule 10b5-2(2), it is for Congress to limit its delegation of authority to the SEC or to limit misappropriation by statute.”

    FINRA

    Market access: The regulator brought a proceeding against Wedbush Securities, Inc. centered on market access and supervisory issues. Specifically, Wedbush is one of the largest market access providers. From January 2008 through August 2013 the firm failed to dedicate sufficient resources to ensure supervise the customers. As a result the U.S. exchanges were flooded with numerous potentially manipulative trades.

    Alert: The regulator issued a warning to investors of Viral Disease Stock Scams (here).

    Criminal cases

    Investment fund fraud: U.S. v. Kretz, 3:09-cr-00262 (M.D. Tenn.) is an action against Terry Kretz, formerly the CEO of Hanover Corporation. The indictment alleged that Mr. Kretz solicited investors over a two year period beginning in early 2004 to purchase promissory notes in the firm. The notes supposedly paid a high rate of interest. The funds were to be used to invest in stock options and startup companies. In fact much of the money was used to repay earlier investors and for salaries and overhead as well as personal items. Mr. Kretz pleaded guilty to counts of conspiracy, securities fraud and wire fraud. He was sentenced this week to serve 14 years in prison followed by three years of supervised release. He was also ordered to pay $14,784,983.75 in restitution. Two co-conspirators previously pleaded guilty and are awaiting sentencing.

    Hong Kong

    Report: The Securities and Futures Commission issued a report summarizing its activities for the period April to June 2014 (here).

    SEC Request For O&D Bar Denied

    August 20, 2014

    A frequently used remedy in Commission enforcement actions is the officer and director bar. A permanent bar has the very harsh effect of precluding the person from being an officer or director of any public company. That, of course, can end the career of an executive, counseling care in its application. One Court recently rejected the SEC’s request for a permanent officer and director bar calling the request “abusive.” SEC v. Nocella, Case No. 4:12-cv-1051 (S.D. Tx. Opinion August 11, 2014).

    The complaint

    Nocella is a financial fraud action against two former bank officers, CEO Anthony Nocella and CFO J. Russell McCann. The complaint centers on what was claimed to be the efforts of Messrs. Nocella and McCann to prop-up Franklin Bank Corp., a Texas based savings and loan holding company. By the second quarter of 2007 the loan portfolio of the financial institution began to deteriorate as the financial crisis unraveled. During the summer of 2007 the two officers received reports that depicted a 24% increase in delinquencies in the loan portfolio compared to the prior three month period.

    Following discussions with an investment bank about a possible sale of the institution, Messrs. Nocella and McCann crafted three plans to improve the appearance of the loan portfolio and thus the operating results of the bank: Fresh Start, Strathmore Modifications and Great News. The first focused on bringing certain residential mortgages which were severely delinquent current by notifying the borrowers that if they made one payment, and agreed to certain other modifications, their loans would be considered current. Ultimately millions of dollars in loans were modified through this program to classify them current.

    The second centered on the Strathmore Modifications. This involved about $13.5 million involving four troubled loans to Strathmore Finance Company and its subsidiaries for construction projects in the Detroit area. By the summer of 2007 Strathmore could not repay the loans and requested a modification. The two defendants secured credit committee approval for a modification of the loans. In October 2007 the FDIC concluded after an examination that the loans should have been reclassified under the applicable GAAP provisions.

    The third was the Great New program, another loan modification program. It involved 28 residential borrows who were severely delinquent. Under the program the borrowers only had to make the next payment to become current. Overall the loan modifications were not in accord with disclosed bank policies and GAAP.

    Collectively, the schemes concealed over $11 million in delinquent and non-performing single family residential loans and $13.5 million in non-performing residential construction loans, according to the complaint. The programs did not save the institution. The bank ended in receivership and the holding company in bankruptcy in 2008. The complaint alleges violations of Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). It requested a permanent injunction, disgorgement, prejudgment interest, civil penalties, officer and director bars and repayment under SOX 304.

    The ruling

    The Court considered the question of remedies against Messrs. Nocell and McCann in ruling on a summary judgment motion. The Court found that under Fresh Start, Franklin sent letters to borrowers who were who were delinquent and modified their loan if the most recent payment was made. This was inconsistent with bank policy. For Strathmore the loans were modified without obtaining new appraisals. Effectively a year’s worth of interest was capitalized. The loans were then misclassified. Through Great News residential mortgages were also modified if the next payment was made. The modification deferred overdue interest to the maturity of the loan.

    The Court then turned to the question of whether an officer or director bar should be imposed. Citing SEC v. Patel, 61, F. 3d 137, 141 (2nd Cir. 1995), six factors were identified for consideration: a) the egregiousness of the violation; b) recidivism; c) roles in the company during the fraud; d) degree of scienter; e) economic stake; and f) likelihood of future violations.

    Here the violations were not egregious, the Court concluded. Franklin devised a plan to allow borrowers to remain in their homes with modified loans that were accounted for incorrectly. “Whatever Nocella and McCann’s role, their actions were not flagrant. They did not profit widely or enrich others with this program,” according to the Court. They were both first time offenders. While they were senior officers of the bank, many at the institution participated in the programs which were disclosed to the FDIC. While being the CEO and CFO makes them “abstractly accountable for the actions of the company . . . This does not mean . . . that they were individually responsible for incorrect accounting.”

    Likewise, neither defendant acted with the intention to defraud the shareholders. When the FDIC disagreed with the Strathmore loan classifications, the pertinent corrections were made. Rather, the acts involved here appear to stem from “a good-faith attempt to manage a floundering bank during a recession. Finally, neither is in a position to violate the securities laws in the future. Mr. Nocella retired and Mr. McCann works for a private bank.

    Based on these findings the Court declined to enter an officer and director bar as to either defendant concluding: “This court recognizes that it is wrong that Franklin Bank Corporation improperly accounted for modified mortgages under their management. It is abusive to seek a permanent bar against two executives who were working for a troubled company in a troubled time without adequate evidence that they were responsible for the improper accounting.”

    SEC Brings An Offering Fraud Action Against A Claimed App Maker

    August 19, 2014

    The SEC brought an action against a reputed “app” manufacturer who sold shares in two different entities beginning first in Colorado and later from Georgia. From each location, and for each entity, the sales pitch was essentially the same. Indeed, investors were told that the second company was just the renamed first. In each instance the result was the same – friends and other investors lost; the defendants profited. SEC v. Gamer, Civil Action No. 1:14-cv-02650 (N.D. Ga. Filed August 15, 2014).

    Defendant Heidi Ann Gamer was home from classes at Dartmouth College with her domestic partner in Colorado when she registered defendant Gamer Economic Systems, LLC or GES in that state. The idea was to market interactive software and technology, including applications for smartphones. A prospectus for GES was developed which identified the new technologies. It explained that initial capital would be raised from investors to be used for operations.

    Coworker’s family members were the initial investors. They were told that that Ms. Gamer had connections to build apps for political campaigns and expected to sell licensing rights for upwards of $10 million. Cash flowed in for the operation, prompting a wider marketing campaign. Now investors were told about a product called “StoryMap.” This app supposedly permitted television viewers to look up the episodic history of a show and purchase items seen on the set.

    Investors from Colorado, New Hampshire and Virginia wired funds to the GES bank account. Over a period of about one year, beginning in August 2011, 17 investors furnished GES and Ms. Gamer with over $400,000. Some received investor agreements which promised quarterly financial statements and 5% of any GES royalties once the firm began to show a profit.

    In July 2012 Ms. Gamer and her partner relocated to Atlanta. The location was closer to several software developers. A new entity was formed, defendant Gamer Media Partners or GMP. Investors were not told that GMP was a new entity. Rather, they were told that GES had changed its name.

    Again investors were solicited using StoryMap. Some investors were told that there was a $1 million contract to use the technology in the Indian film industry. Others were told that a partnership had been formed that would make available $2 million for the exclusive licensing of StoryMap. In some sales pitches potential investors were told of a $100,000 contract with Dartmouth College and a deal with the Atlanta Falcons. Between August 2012 and May 2013 Ms. Gamer sold interest to 27 investors, raising over $370,000 for interests in GMP.

    The contracts did not exist. The funds were not used to develop the business as

    represented. Rather, much of the money was diverted to personal use. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 23071 (August 19, 2014).

    SEC Brings Another Insider Trading Case Tied To Golf

    August 18, 2014

    Golf is becoming a recurring theme in insider trading cases. Last month the SEC brought an insider trading action against a group of golf friends. That action, detailed here, was supported by a series of e-mails among the group which documented their scheme. Now the SEC has brought another insider trading case related to golf. This action is also tied to golf but is not supported by e-mails. SEC v. O’Neill, Civil Action No. 1:14-cv-13381 (D. Mass. Filed August 18, 2014).

    The action focuses on the June 29, 2010 announcement that Wainwright Bank & Trust Company was going to be purchased by Eastern Bank Corporation. It involves then Eastern Senior Vice-President and Senior Credit Officer J. Patrick O’Neill and Robert Bray, an affiliate of R&B Construction Company.

    Mr. O’Neill joined Eastern Bank in early 2010 as a Senior Vice President. At the time he read and acknowledged the insider trading policy of the bank. A few days later the bank asked him to also execute a confidentiality agreement. That agreement stated in part that Eastern was involved in a possible transaction regarding Wainwright and that he would likely receive confidential information. It also noted that he likely would conduct due diligence on the proposed deal and that the information he would obtain was “inside information” under the applicable securities laws. Subsequently, Mr. O’Neil conducted due diligence on Wainwright’s loan portfolios. That work was completed by June 28, 2010.

    Messrs. O’Neill and Bray had been friends for many years. Both were golfers and members of the same local country club. Both socialized at the country club bar. The year before Mr. O’Neil joined Eastern Bank R&B Construction hired his college freshman son to do computer work. In June 2010 the son listed Mr. Bray as an employer reference.

    On one or more days between May 20 and June 13 the two men were together, according to the complaint. On Monday June 14, 2010 Mr. Bray sold the shares of three other stocks in his brokerage account for total proceeds of over $261,000. He used the proceeds to purchase Wainwright shares. Over a period of days beginning on June 14 he accumulated 31,000 shares of Wainwright stock at a cost of over $288,000. When the deal was announced the share price spiked up 94% giving Mr. Bray profits of almost $300,000.

    In August 2010 Mr. O’Neill resigned from the bank after the legal department circulated a FINRA letter which was part of an insider trading inquiry. It iisted names which included his. Just before his resignation from the bank Mr. O’Neill transferred the family home into the name of his wife. Later, when requested to testify during the Commission’s investigation both Mr. O’Neill and Mr. Bray declined to testify, citing their Fifth Amendment privilege. The Commission’s complaint alleges violations of Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 230790 (August 18, 2014).

    The U.S. Attorney’s Office for the District of Massachusetts has filed parallel criminal charges against Mr. O’Neill.

    Third Circuit Rejects Claim that Fiduciary Duty Required For Insider Trading

    August 17, 2014

    Insider trading cases frequently turn on the nature of the relationship between the trader and the person who is the source of information. The breach of that relationship of trust and confidence can supply the statutory element of deception, the predicate for a violation of Exchange Act Section 10(b). In Rule 10b5-2 the SEC defined three instances when a duty of trust and confidence exists: 1) When a person agrees to maintain information in confidence; 2) When there is a history, pattern or practice of sharing confidences giving rise to an expectation of such on the part of the communicator; and 3) when the information comes from a spouse, parent, child or sibling. In U.S. v. McGee, No. 13-3183 (3rd Cir. Decided August 14, 2014) the Court rejected a claim that the SEC exceeded its authority when enacting Rule 10b5-2 because it did not require a fiduciary duty.

    Timothy McGee was convicted by a jury of insider trading. That conviction is based on the misappropriation theory. Between June and July 2008 he obtained material non-public information regarding the then pending sale of Philadelphia Consolidated Holding Corporation or PHLY from Christopher Maguire, an insider at the company. Mr. McGee then borrowed about $226,000 to purchase 10,750 shares of PHLY. After the deal announcement he had trading profits of $292,128.

    Messrs. McGee and Maguire met between 1999 and 2001 while attending meetings of Alcoholics Anonymous. Over the next several years Mr. McGee informally mentored Mr. Maguire at AA. During that time the two men frequently exchanged confidential information. In 2008 Mr. Maguire was closely involved in the negotiations to sell PHLY. During the period he suffered sporadic alcohol relapses. After one meeting Mr. McGee inquired about frequent missed meetings by Mr. Maguire. In response Mr. Maguire blurted out the inside information. Following the conversation Mr. McGee made the stock purchases. A jury convicted him of insider trading based in part on Rule 10b5-2. The district court rejected Mr. McGee’s challenge to the Rule as exceeding the SEC’s authority.

    The traditional model of insider trading is based on the corporate executive who trades in the shares of his or her company while in possession of inside information, the Court began. That trading is a deceptive practice within the meaning of Exchange Act Section 10(b) since the insider violates a relationship of trust and confidence. In contrast, the misappropriation theory of insider trading focuses on outsiders who owe no duty to shareholders. Those outsiders do, however, owe a duty to the source of the information. Under either theory, deception through nondisclosure is the crux of insider trading liability.

    The Supreme Court has provided limited guidance on the precise limits of the duty. In U.S. v. O’Hagan the Court noted only that it has to be a recognized duty. This has spawned inconsistent decisions in the lower courts. For example, in U.S. v. Kim the district court held that there was no duty of confidentiality between members of a social group of CEO’s despite club rules emphasizing confidentiality. Yet in SEC v. Kirch another district court concluded that the necessary duty was present between members of a group of software executives because the need for confidentiality was understood.

    Here Mr. McGee challenges Rule 10b5-2(2), arguing that it exceeds the SEC’s authority since a fiduciary duty is required. Turing to the question of whether the SEC is entitled to difference under Chevron, the Court first sought to determine if Section 10(b) is ambiguous on the precise question. Section 10(b), the Court concluded, is ambiguous since it does not define “deceptive device” and, in fact, does not mention insider trading much less define the necessary type of relationship.

    The critical question then becomes whether judicial precedent foreclosed the action taken by the SEC. Mr. McGee claimed that Supreme Court precedent precluded the action taken by the SEC with respect to the Rule. The Court disagreed, however, noting that O’Hagan and other decisions by the Supreme Court in this area do not specifically define the type of relationship necessary. While those decisions frequently discuss fiduciary relationships, they do not specifically require such a relationship.

    Since there is no specific judicial precedent defining the necessary relationship, the question is if the SEC’s construction is one it permissibly could have adopted. Considering the purpose of the Act the Court determined that “Rule 10b5-2(2) is based on a permissible reading of ‘deceptive device[s]’” under Section 10(b) of the Exchange Act. The Court concluded by noting that “Although we are not without reservations concerning the breath of misappropriation under Rule 10b502(2), it is for Congress to limit its delegation of authority to the SEC or to limit misappropriation by statute.”

    This Week In Securities Litigation (Week ending August 15, 2014)

    August 14, 2014

    The Commission prevailed in two litigated actions. In one the agency secured a favorable jury verdict in an action centered on misrepresentations made by an investment adviser who sought to move his book of business to a new entity. In the second, a jury returned a verdict in favor of the SEC in a microcap fraud action.

    The SEC also brought actions based on: insider trading,; excessive brokerage charges; investment fund fraud; net capital violations; the sale of municipal bonds; and for aiding and abetting and covering-up an investment fraud.

    SEC Enforcement – Litigated Actions

    Misrepresentations: SEC v. Sage Advisory Group, LLC, Civil Action No. 1: 10-cv-11665 (D. Mass.) names as defendants the advisory and its principal, Benjamin Grant. The action centered around Mr. Grant’s efforts to transfer his brokerage clients to his newly formed advisory service, Sage. Prior to October 2005 Mr. Grant was a registered representative at broker dealer, Wedbush Morgan Securities in Los Angeles, California. He had a substantial book of business with over 300 customer accounts holding more than $100 million in assets. To induce his clients to move to his new firm he made a series of misrepresentations and failed to tell them that the new fee structure would largely benefit him. The complaint alleged violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2), 206(4), 207 and 204A. The case was submitted to the jury on Counts based on Advisers Act Sections 206(1), 206(2), 207, 206(4)) and 204A. The jury returned a verdict in favor of the SEC on each except the Section 207 claim. See Lit. Rel. No. 23066 (August 13, 2014).

    Microcap fraud: SEC v. BIH Corporation, Civil Action No. 2:10-cv-577 (M.D. Fla.).

    The case named as defendants: BIH, a penny stock company which claimed to be a holding company specializing in the restaurant and hospitality industry; Edward Hayter who controlled BIH with Wayne Burmaster, Jr.; NorthBay South Corporation, supposedly an investment bank which acted as statutory underwriter by selling unregistered shares of BIH; Bimini Reef Real Estate, Inc., a firm which supposedly is in the real estate business and also acted as a statutory underwriter regarding BIH; Riverview Capital, Inc., also a statutory underwriter for BIH; Christopher Alstrom, the president of Bimini Reef; and Damian Guthrie, also involved in the distribution of BIH shares.

    The complaint alleges a typical pump and dump manipulation scheme. It claimed that BIH presented a fictitious president and CEO on its website who was represented to be an accomplished entrepreneur. False press releases were issued such as one claiming that the firm had received an unsolicited offer to pay up to 20 cents a share for its stock and another that contained quotes from the fictitious president stating that shares were materially undervalued. Finally BIH shares were illegally distributed to North Bay South Corporation and Bimini Reef, Riverview Capital, all controlled by members of the scheme, yielding over $1.1. The complaint, filed in 2010, alleged violations of Securities Act Sections 5(a) and 5(c), each subsection of Section 17(a) and Exchange Act Section 10(b). The four day trial was only against Mr. Hayter. The SEC prevailed on each count.

    SEC Enforcement –Filed and Settled Actions

    Statistics: This week the Commission filed 2 civil injunctive actions and 4 administrative proceedings (excluding 12j and tag-along proceedings).

    Insider trading: SEC v. Toth, Civil Action No. 1:14-CV-02616 (N.D. Ga. Filed August 13, 2014) is an action against Donald Toth, a certified public accountant, and James Nash, one of his clients. It centers on the tender offer for O’Charley’s, Inc. by Fidelity National Financial, Inc., announced on February 6, 2012. About two months before the tender offer announcement a Director of O’Charley’s told Mr. Toth about the pending transaction when seeking tax advice. Within days Mr. Toth purchased 5,000 shares of O’Charley’s stock. He also informed two of his clients, James Nash and Blair Schlossberg (charged in a separate action below). Both traded. Mr. Nash purchased 3,5000 shares of O’Charley’s stock. Mr. Schlossberg and his long time business partner Moshe Manoah jointly purchased 24,337 shares of stock. Following the announcement the share price increased about 42% giving Mr. Toth profits of $19,036, Mr. Nash profits of $13,959 and Messrs. Schlossberg and Manoah (also charged in a separate action) profits of $92,717. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). Each trader settled, consenting to the entry of permanent injunctions prohibiting future violations of the Sections cited in the complaint. In addition, each defendant agreed to pay: Mr. Toth, disgorgement of $19,036 along with prejudgment interest and a penalty of $103,935.50; Mr. Nash, disgorgement of $52,500 along with prejudgment interest and a penalty equal to his trading profits; Mr. Schlossberg, disgorgement of $46,358 along with prejudgment interest and a penalty equal to his trading profits; and Mr. Manoah, disgorgement of $46,358.50 along with prejudgment interest and a penalty equal to his trading profits. See Lit. Rel. No. 23068 (August 14, 2014); see also SEC v. Manoah (M.D. Fla. Filed August 13, 2014) which names as defendants Moshe Manoah and Blair Schlossberg.

    Excessive brokerage charges: In the Matter of Linkbrokers Derivatives LLC, Adm. Proc. File No. 3-16017 (August 14, 2014) is a proceeding which names the broker-dealer as a Respondent. The firm ceased acting as a broker in 2013 and will withdraw its registration at the conclusion of this action. From 2005 through early 2009 on over 36,000 customer transactions three brokers engaged in a scheme to charge customers false prices which concealed hidden markups or markdowns. The scheme is described here, in the description of the action previously brought by the Commission against the brokers (who have also now pleaded guilty to parallel criminal charges), Benjamin Chouchane, Marek Leszczynski and Henry Condron. The firm resolved the charges, consenting to the entry of a cease and desist order based on Exchange Act Section 15(c) and a censure. The firm will also pay disgorgement of $14 million.

    Unregistered securities: SEC v. Garber, Civil Action No. 12 Civ. 9339 (N.D.N.Y.) is a previously filed action against Danny Garber, Michael Manis, Kenneth Yellin, Jorda Feinstein and a number of entities. The complaint initially alleged a scheme in which the defendants acquired shares of penny stock companies at significant discounts based on claims that they would hold them. Instead the unregistered shares were sold quickly without any exemption. The complaint alleged violations of Securities Act Sections 5(a) and 5(c) and 17(a) and Exchange Act Section 10(b). The second amended complaint dropped the antifraud charges. This week the Court entered final judgments against each individual defendant, enjoining them from violating Section 5 of the Securities Act and requiring them to pay a penalty of $25,000. The final judgment against Mr. Garber also included a penny stock bar. In addition, Messrs. Manis, Yellin and Feinstein were permanently enjoined from participating in any offering made pursuant to Rule 504 of Regulation D. Mr. Manis will pay disgorgement of $862,000 along with prejudgment interest; Messrs. Yellin and Feinstein will each pay disgorgement of $314,550 along with prejudgment interest. The entity defendants agreed to the entry of permanent injunctions based on Securities Act Section 5. See Lit. Rel. Nos. 23065 (August 13, 2014) and 22579 (Dec. 21, 2012).

    Investment fund fraud: In the Matter of Keith MacDonald Summers, Adm. Proc. File No. 3-16014 (August 13, 2014) is a proceeding against the managing member of Tricoastal Capital Partners, LLC, an unregistered investment advisory firm. From mid-2009 through mid-2013 Mr. Summers raised about $4.7 million for the fund, primarily from U.S. investors. In raising the funds he misrepresented the amount of assets under management, the intended use of the funds and later concealed losses while misappropriating funds. Eventually he turned himself into Canadian authorities and pleaded guilty to criminal charges. This proceeding alleged violations of Securities Act Section 17(a) and Exchange Act Section 10(b) as well as Advisers Act Sections 206(1), 206(2) and 206(4). To resolve the proceeding Mr. Summers consented to the entry of a cease and desist order based on the Sections cited in the order. He also agreed to be barred from the securities business and pay disgorgement of $4,117,658.15 much of which is satisfied by the payment of restitution in the criminal case.

    Net capital: In the Matter of Crucible Capital Group, Inc., Adm. Proc. File No. 3-16008 (August 8, 2014) is a proceeding which names as Respondents the registered broker dealer and its founder, Charles Moore. The proceeding alleges that Crucible not only failed to meet and maintain net capital but also took affirmative steps to conceal the fact that it had failed to comply with its obligations. The Order alleges violations of Exchange Act Sections 15(c)(3) and 17(a)(1). It will be set for hearing. Parallel criminal charges were filed by the U.S. Attorney in Manhattan.

    In the Matter of The State of Kansas, Adm. Proc. File No. 3-16009 (Aug. 11, 2104) is the third action brought by the SEC against a state centered on the failure to disclose unfunded pension liabilities when selling bonds. Beginning in August 2009, and continuing for about the next year, the Kansas Development Finance Authority or KDFA raised $273 million through eight series of bonds offered on behalf of the State and its agencies. KDFA is an independent instrumentality of the state. Its primary purpose is to enhance the ability of the state to finance capital improvements. As a conduit issuer, the instrumentality offers securities on behalf of underlying issuers. The pension fund in the state, KPERS, is an independent instrumentality. It covers most government and public service employees. It also covers local school districts. Annually it prepares and releases an actuarial valuation and comprehensive annual financial report or CAFR. During the offering period KPERS was underfunded. At the end of 2008 its unfunded actuarial accrued liability was about $8.3 billion. It had a 59% funded ration. By contrast the tax supported debt of the state was $3.1 billion. The Official Statements for the eight series of bonds issued beginning in August 2009 included statements regarding the risk of non-appropriation. Information was also included regarding the amount of certain state indebtedness. There was no mention of the underfunded status of KPERS. At closing certificates were issued certifying that all material information was disclosed and correct.

    Once the deficiencies in the disclosures came to light, Respondent undertook prompt remedial measures. The Order alleges violations of Securities Act Sections 17(a)(2) and (3). The State resolved the proceeding by consenting to the entry of a cease and desist order based on the Sections cited in the Oder.

    SEC v. Brown, Civil Action No. 1:14-cv-06130 (N.D. Ill. Filed August 8, 2014) is an action which names as defendants Alliance Investment Management Limited, or AIM, a Bahamian broker dealer registered with the SEC, and its president, Julian R. Brown. At its center is former investment management star, Nikolai Battoo. Mr. Battoo was a principal of BC Capital Group S.A. and BC Capital Group Limited. At his peak Mr. Battoo claimed to have about $1.5 billion under management. When his funds suffered huge losses during the market crisis and as a result of the Madoff Ponzi scheme, he covered it up with false account statements. Mr. Brown and AIM directly participated in, and substantially assisted, Mr. Battoo’s fraud. Throughout the period AIM represented that it was the independent custodian for PIWM investments. The custodian was supposed to safeguard the investments. In fact, after receiving investor proceeds AIM did not retain custody of them. Rather, at the direction of Mr. Battoo, the assets were forwarded to him. This facilitated the misappropriation of over $45 million, according to the complaint. In addition, Mr. Brown distributed false account statements prepared by Mr. Battoo. Mr. Brown and AIM profited from their work with Mr. Battoo. About $5 million was placed with the firm as a so-called investment by Mr. Battoo. In addition, Mr. Brown and AIM were paid significant fees. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is in litigation. See also SEC v. Battoo, Civil Action No. 12 C 7125 (N.D. Ill.); CFTC v. Battoo, Civil Action No. 12 C 7127 (N.D. Ill.); In the Matter of Larry C. Grossman, Adm. Proc. File No. 3-15617 (Nov. 20, 2013).

    Unregistered broker-dealer: In the Matter of Fred Golt, Adm. Proc. File No. 3-16012 (August 12, 2012) is a proceeding against Mr. Gold alleging violations of Exchange Act Section 15(a). From April 2012 through February 2012, according to the Order, Mr. Golt solicited investors for Mutual Entertainment, LLC which was seeking to raise money for a motion picture. For his efforts in placing the securities through a team of sales people called “fronters” he was paid $337,825 in transaction based compensation. He was not a registered broker-dealer. The fronters were paid from those fees. Mr. Golt’s profits were negligible, although he would have been paid more had Mutual Entertainment been successful. To resolve the proceeding Mr. Golt consented to the entry of a cease and desist order based on Section 15(a) of the Exchange Act. He was also barred from the securities business and from participating in any penny stock offering. In addition, he a will pay a civil penalty of $25,000.

    FINRA

    Alert: The regulator issued a warning to investors of Viral Disease Stock Scams (here).

    Australia

    Investment scheme: The Australian Securities and Investment Commission announced that Mark Letten was sentenced to serve five years and eight months in prison based on charges tied to a real estate investment scheme. Mr. Letten is a former director of LGH Holdings Ltd and the principal of the accounting firm Letten Pty Ltd. Between 1998 and 2010 more than 1,000 investor, most from Mr. Letten’s accountancy practice, placed more than $100 million in investment property schemes managed and promoted by Mr. Letten. The companies and unregistered schemes were wound-up with investors suffering losses of a least $67 million. Mr. Letten pleaded guilty to 27 charges including operating 21 unregistered schemes.

    Insider trading: The ASIC announced that Fei Yu had been charged with eight counts of insider trading. The charges center on the take-over of Veda Advantage Limited by Pacific Equity Partners in 2007. Mr. Yu learned about the deal prior to the public announcement from his close friend, Bo Shi Zhu, an executive at Caliburn Partnership Ptd. which advised Veda. After learning about the deal he purchased securities and aided with the acquisition of contracts for difference. Mr. Yu made about $20,000 on the transaction. The maximum penalty for the charges is five years in prison. That maximum was recently increased to ten years. Previously, Mr. Zhu was sentenced to serve a term of two years and three months with a minimum of 18 months in prison.

    Hong Kong

    Insider trading: The Securities and Futures Commission brought a proceeding against Salina Yu Lai Si, the former CEO of Water Oasis Group Ltd. The action, which charges insider trading, alleges that in January 2012 Ms. Yu was informed that H2O would terminate the exclusive distributorship of Water Oasis. Shortly after receiving the notice Ms. Yu sold all of her Water Oasis shares, avoiding a loss of over $280,000. The proceeding is pending.

    Misrepresentations: The SFC suspended Chan Hung Nin for 15 months. The disciplinary action is based on the fact that he operated a client account as discretionary from early April 2011 through about mid-August 2012 when in fact it was not. He attempted to conceal this fact by having the client make false representations to the brokerage firm.