July 28, 2014
Entering into new, international markets may be good for developing business, but it also carries certain risks. This is particularly true in many countries where doing business may include making gifts, paying gratuities and even bribes. The difficulties can be compounded if adequate preparations are not undertaken, including bolstering internal controls and ensuring that adequate FCPA compliance procedures. Firearms manufacturer Smith & Wesson Holdings Company, learned this lesson the hard way. In the Matter of Smith & Wesson Holdings Corporation, Adm. Proc. File No. 3-15906 (July 28, 2014).
Smith & Wesson sought to break into international markets beginning in 2007. The goal was to increase sales. At the time the company did not have any international subsidiaries. It sought to conduct its international business directly through brokering agents.
In seeking business in international markets, the company focused on selling firearms to foreign law enforcement and military departments. In 2008, for example, the firm retained a third party agent in Pakistan to assist in dealing with sales to a local police department. The agent told the company it would have to provide guns worth over $11,000 to the police department to obtain a deal. Additional cash payment would also be required. The Vice President of International Sales and the Regional Director of International Sales authorized the gifts and payment. Ultimately Smith & Wesson sold 548 pistols to the Pakistani police for $210,980, yielding profits of $107,852.
The next year the company sought to secure a contract to sell firearms to a police department in Indonesia. A third party agent told the company that payments would have to be made under the guise of legitimate firearms lab testing costs. The inflated payments were authorized. No deal was consummated. The company also authorized improper payments through a third party agent in Nepal and Bangladesh. No contracts were obtained. Indeed, by the time the improper conduct surfaced, the company had only secured one contract.
Throughout the period Smith & Wesson had inadequate policies and procedures. Specifically, its internal controls were inadequate. The company did not perform any anti-corruption risk assessment and did virtually no due diligence on third party agents. The firm’s FCPA compliance procedures were also inadequate.
The Order alleges violations of Exchange Act Sections 30A, 13(b)(2)(A) and 12(b)(2)(B). The Commission acknowledged the cooperation of the firm which included conducting an internal investigation, terminating its entire international sales staff, terminating pending international transactions and re-evaluating the markets in which it was seeking business. The company also agreed to a series of undertakings which include reporting to the staff at six to twelve month intervals over two years on its remediation and compliance efforts. The firm will also submit a complete report of its remediation efforts to the staff and conduct follow-up reviews which incorporate the comments provided by the staff.
Smith & Wesson consented to the entry of a cease and desist order based on the Sections cited in the Order. It will pay disgorgement of $107,852, prejudgment interest and a civil penalty of $1,906,000.
The Department of Justice declined prosecution according to a recent company filing.
July 27, 2014
Fragmented markets, alternative trading systems and dark pools are increasingly a focus of discussion in the wake of repeated market outages. Interest in these venues has been intensified by the publication of Flash Boys and Dark Pools. To date only a few cases have been brought. See, e.g. In the Matter of Liquidnet, Inc., Adm. Proc. File No. 3-15912 (June 6, 2014)(ATS dark pool where confidential customer data used for marketing); In the Matter of eBX, LLC, Adm. Proc. File No. 3-15058 (Oct. 3, 2012)(informational edge given to another); In the Matter of Pipeline Trading Systems, LLC., Adm. Proc. File No. 3-1460 (Oct. 24, 2011)(concealed conflict re order filling process).
On Friday the Commission added to its increasing number of cases in this area, filing an action against a unit of Citigroup, In the Matter of LavaFlow, Inc. Adm. Proc. File No. 3-15985 (July 25, 2014). Respondent LavaFlow, Inc. is a registered broker-dealer which is an indirect subsidiary of Citigroup Global Markets, Inc. It operates LavaFlow ECN, an electronic communications network which is a particular type of ATS. Generally, it functions as a marketplace for buyers and sellers of securities. LavaFlow ECN displays the top of its order book which is the best bid and best buy in the national market system. Other orders are not displayed.
In 2006 Lava Trading, a subsidiary of Citigroup, acquired the ECN which became known as LavaFlow ECN. Prior to that time Lava Trading had functioned as a technology services company. Its flagship product was ColorBook, software that provided smart order routing services for over 100 registered broker-dealers that used it to route their customer orders to execution venues. As a smart order router, ColorBook applied preprogrammed analytics that carried out an execution strategy. This distinguished ColorBook from an order router which generally allows an end user to submit an order to an execution venue.
When LavaFlow ECN was acquired, Lava Trading personnel believed they could use ColorBook to improve important functions of the ECN. Nevertheless, the services that ColorBook provided to customers remained distinct from those provided by LavaFlow ECN.
Initially, LavaFlow did not permit ColorBook to access and use information from the ECN direct subscriber non-display order flow when determining how to smart route orders. Beginning in March 2008, and continuing for the next three years, LavaFlow did permit ColorBook to access that information and use it for smart order routing decisions for customers who also were subscribers of the ECN. Thus if an ECN customer placed an order that would match a non-displayed order in the venue, ColorBook would route the customer order to the LavaFlow ECN with the expectation that the two orders would match.
LavaFlow did not obtain meaningful consent from its ECN subscribers to allow ColorBook to have access to direct subscriber non-displayed order flow information or to use it. While marketing materials indicated that ColorBook would be “exposed” to non-displayed order flow data, there was no procedure in place to ensure that subscribers reviewed this material. There is no indication that non-displayed orders were communicated to customers of the smart order routing business.
In June 2008 Lava Trading, which had been a registered broker-dealer since 2005, withdrew its registration. The next year Lava Trading entered into an agreement with LavaFlow under which the latter would receive all income associated with contractual arrangements that previously existed between Lava Trading and its customers. From August 2008 through February 2009 Lava Trading received transaction-based compensation for broker-dealer services, including about $1.8 million for orders handled by the smart order router.
The Order alleges willful violations of Rules 301(b)(2) and (10) of Regulation ATS and Exchange Act Section 15(a). Rule 301(b)(10) requires an ATS to establish adequate safeguards and procedures to protect subscribers’ confidential trading information and to have adequate oversight. This rule was violated by permitting ColorBook to have access to the direct subscriber non-displayed order flow information and use it to make routing decisions. Rule 301(b)(2) requires an ATS to amend its Form ATS before implementing a material change to its operation. That form was not amended here regarding the access of ColorBook.
To resolve the proceeding LavaFlow consented to the entry of a cease and desist order based on the Rules and Section cited in the Order and to a censure. It also agreed to pay disgorgement of $1.8 million, prejudgment interest and a civil penalty of $2,850,000.
July 24, 2014
This Week In Securities Litigation (Week ending July 25, 2014)
The Commission issued its long discussed rules reforming money markets this week, requiring that institutional prime money market funds have a floating NAV. The vote was 3-2.
In the Court of Appeals the SEC lost its effort to compel SIPIC to cover certain losses related to the Stamford Ponzi scheme. SEC Enforcement filed six actions this week. Two were tied to a prior actions centered on the sale of unregistered securities; one is a market crisis action tied to the sale of RMBS; another centered on a microcap fraud; and one alleged insider trading charges by an IR adviser.
Rules: The Commission adopted money fund reform rules which require a floating net asset value for institutional prime money market funds. The agency also issued a related notice proposing exemptions from certain confirmation requirements for transactions effected in shares of floating NAV money market funds and proposed amendments to certain related rules regarding references to credit ratings (here).
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed, or announced the filing of, 5 civil injunctive actions, DPAs, NPAs or reports and 1 administrative proceeding (excluding follow-on and Section 12(j) proceedings).
Unregistered securities: SEC v. DDBO Consulting, Inc., (S.D. Fla. Filed July 24, 2014) is an action against the company, DBBG Consulting, Inc., Dean Baker, the president of both entities, and Bret Grove, a vice president of DBBG. Defendants sold unregistered shares of Thought Development, Inc. to at least 100 investors from July 2011 through November 2012. Thought Development, a defendant in a previously filed enforcement action, supposedly developed a laser-line system that can be used in professional and collegiate sporting events as described more fully here. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and each subsection of 17(a) and Exchange Act Sections 10(b) and 15(a). The defendants have agreed to settle but the terms were not disclosed. This action is related to the next case. The U.S. Attorney for the Southern District of Florida also filed criminal charges against Messrs. Baker and Grove as well as two individuals named in the initial complaint against Thought Development.
Unregistered securities: SEC v. Calpacific Equity Group, LLC, Civil Action No. 2:14-cv-05754 (C.D. Cal. Filed July 24, 2014) is an action against the firm, Daniel Baker, its managing director, and Demosthenes Dritsas, a managing member of the firm. This action alleges that during about the same time period as the action against DDBO Consulting the defendants sold unregistered shares in Thought Development, Inc. to at least 34 investors. The complaint alleges violations of the same Sections as the DDBO complaint. The defendants have agreed to settle with the Commission. The terms were not disclosed. The U.S. Attorney for the Central District of California brought criminal charges against Messrs. Baker and Dritsas who have entered guilty pleas in the case.
Market crisis: In the Matter of Morgan Stanley & Co. LLC, Adm. Proc. File No. 3-15982 (July 24, 2014) is a proceeding naming the firm, a registered broker-dealer, as a Respondent along with two of its subsidiaries. The action centers on two subprime residential mortgage-backed securities transactions in 2007. The two transactions had an aggregate principal value balance of over $2.5 billion. At the time of the offerings the subprime residential real estate market was unraveling and delinquency rates were spiking upward. The firm had a practice of making RMBS offerings with delinquency rates of 1% or less. In the two offerings involved here the disclosure documents recited that the delinquency rates for 30 to 60 days were 1% or less as to each pool’s aggregate principal balance as of the date on the documents. At the time Morgan Stanley had historical delinquency data for the one offering showing a 17% delinquency rate at some point since origination. For that same offering the bank used payment data that post-dated the closing date in the documents which also impacted the delinquency rate. As to the other offering, after the closing date in the documents Morgan Stanly learned that the rate was actually 4.5%. As a result the information given to investors was incorrect, according to the Order. The Order alleges violations of Securities Act Sections 17(a)(2) and (3). To resolve the proceeding, Respondents consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition they agreed, on a joint and several basis, to pay disgorgement of $160,627,852, prejudgment interest and a civil penalty of $96,376,711. The payments will be placed in a fair fund. Respondents agreed that in any private action they would not claim an offset based on the civil penalty paid in this proceeding.
Investment fraud: SEC v. International Stock Transfer, Inc., Civil Action No. 14-cv-4435 (E.D.N.Y. Filed July 23, 2014) is an action against the firm, a transfer agent, and its owner, Cecil Franklin Speight. The defendants raised about $3.3 million from over 70 investors who were induced by boiler room tactics to purchase shares which were supposed to be safe and have a high rate of return. The appearance of safety was bolstered by having payments sent to attorneys. What investors received was fake stock certificates. The defendants misappropriated the investor funds. The complaint alleges violations of Securities Act Sections 17(a), Exchange Act Sections 10(b) and 17(a)(3). To partially resolve the action each defendant consented to the entry of judgments permanently enjoining them from future violations of the securities laws and requiring them to pay disgorgement, prejudgment interest and penalties in amounts to be determined by the Court. Defendant Speight also consented to the entry of an officer and director bar and a penny stock bar. In a parallel criminal case he also pleaded guilty to a criminal charge. See Lit. Rel. No. 23050 (July 24, 2014).
Insider trading: SEC v. McGrath, Civil Action No. 14 CV 5483 (S.D.N.Y. Filed July 22, 2014) is an action against Kevin McGrath, a partner at investor relations firm Cameron Associates. The complaint alleges that Mr. McGrath traded in the shares of two firm clients after working on their press releases but before those releases were issued. The clients are Misonix, Inc. and Clean Diesel Technologies, Inc. First, in April 2009 Mr. McGrath purchased 10,000 shares of Misonix stock. Later that same month he began communicating with the company on an Earnings Release which contained disappointing news. After learning when it would be issued he immediately sold his shares. When the share price dropped about 36% after the release was issued he avoided losses of $5,400.
Second, in May 2011 Mr. McGrath was involved in drafting a release for Clean Diesel. It announced a new contract. After learning its release date he immediately purchased 1,000 shares of Clean Diesel stock. After the issuance of the release the share price increased 95%, giving Mr. McGrath profits of $6,376. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Mr. McGrath resolved the matter, consenting to the entry of an injunction which prohibits future violations of the Sections cited in the complaint. It also contains provisions to implement the order. In addition, he agreed to pay disgorgement of $11,776, prejudgment interest and a penalty equal to the amount of the disgorgement. See Lit. Rel. No. 23049 (July 22, 2014).
Insider trading: SEC v. Canas, Civil Action No. 13-cv-5299 (S.D.N.Y.) is a previously filed action against Cedric Canas Maillard, an executive advisor to the CEO of Banco Santander, and his friend, Julio Marin Ugedo. It alleged that the two men traded on inside information about the acquisition of Potash Corporation by BHP Billiton in which the bank was involved. Both men traded in advance of the deal announcement. Mr. Canas had profit of $917,239 while his friend had $43,566. Mr. Canas settled, and the Court entered an order prohibiting future violations of Exchange Act Sections 10(b) and 14(e). Mr. Canas also agreed to pay disgorgement in the amount of the total profits of both defendants, and a civil penalty equal to that amount which is $960,806. See Lit. Rel. No. 23048 (July 22, 2014).
Microcap fraud: SEC v. Plummer, Civil Action No. 14 CV 5441 (S.D.N.Y. Filed July 18, 2014) is a microcap fraud action which names as defendants: Christopher Plummer, the CEO of Franklin Energy and Madison & Wall Investments, LLC, and a recidivist fraudster currently in prison; Lex Cowset, the CEO of CytoGenix, Inc., a microcap pharmaceutical company; and GyroGenix. The complaint centers on two schemes involving joint ventures with Franklin Energy. In the first, Company A, supposedly a successful securities company, claimed to be transforming into renewable energy through a joint venture with a Franklin subsidiary. Despite a series of web postings and releases touting the venture, neither company had the resources to implement it. Yet it had market impact. The second scheme was similar, but involved CytoGenix which had lost all of its intellectual property in the pharmaceutical area through litigation. Again a joint venture was touted with Franklin. Its purpose was to identify and develop biologically based technologies for energy production. About $330,000 was raised through an offering. Again, neither company had the resources to implement the venture. The investor funds were misappropriated. The complaint alleges violations of Exchange Act Sections 10(b) and 20(b) and Securities Act Section 17(a). The case is in litigation. See Lit. Rel. No. 23047 (July 18, 2014).
Insider trading: U.S. v. Wang, 3:13-cr-03487(C.D. Calif. Filed Sept. 20, 2013) is a case in which former Qualcomm Inc. executive Jing Wang pleaded guilty to insider trading and money laundering. In three instances beginning in 2010 he traded on inside information obtained from his employer. The trades resulted in over $250,000 in profits. His broker and longtime friend, Gary Yin, placed the trades and in two instances also traded for his own account. The money laundering charge was based on the efforts of Mr. Wang to transfer over $525,000 from an offshore account he controlled that included about $250,000 from the insider trading to another nominee brokerage account in the British Virgin Islands. As part of the plea agreement Mr. Wang also admitted to fabricating evidence and a false cover story in conjunction with his brother Bing Wang and Mr. Yin. Mr. Wang’s sentencing has not been scheduled. See also SEC v. Wang, Civil Action No. 3:13-cv-02270(S.D. Cal. Filed Sept. 23, 2013).
Bernd Kowaleski, formerly the CEO of BizJet, a subsidiary of Lufthansa Technik, AG, pleaded guilty to one count of conspiracy and one substantive FCPA violation. Mr. Kowaleski is the third company executive to plead guilty. The underlying scheme involved the payment of bribes, in some instances through shell companies, to officials in Mexico and Panama to secure contracts for aircraft maintenance repair and overhaul contracts. Previously the company entered into a deferred prosecution agreement. U.S. v. Bizjet International Sales & Support Inc., Case No. 12-cr-61 (N.D. Okla. March 14, 2012).
MOU: The Board announced that it had entered into a cooperative agreement with the Danish Business Authority for the oversight of audit firms subject to the regulatory jurisdictions of both regulators. It takes effect immediately. The agreement provides a framework for inspections and provides for cooperation and the exchange of confidential information.
Court of Appeals
SIPIC coverage: SEC v. SIPC, No. 12-5286 (D.C. Cir. Decided July 18, 2014) is an action in which the SEC sought to compel SIPIC to provide coverage for those who purchased CDs from Stanford International Bank, LTD, an offshore bank that was part of the Stanford empire. Those who purchased CD’s did so on the recommendation of the Stanford Group Company, a Huston-based broker-dealer registered with the SEC.
The District Court concluded that SIPIC was correct in determining that the CD purchasers are not customers of the broker-dealer within the meaning of the Act, a prerequisite to coverage.
The Circuit Court affirmed. The critical question here, according to that Court, is whether those who purchased bank CD’s at the suggestion of the broker-dealer are customers for purposes of the Securities Investor Protection Act. A customer is generally defined as a person who has deposited cash with the broker for the purpose of purchasing securities. A claimant must generally demonstrate that the broker received or held the claimant’s property and that the transaction gave rise to the claim and contained the indicia of a fiduciary relationship between the customer and the broker.
In this case the purchasers of SIBL CDs are not customers within the meaning of the Act, the Court held. It is undisputed that the investors did not deposit cash with SGC. Since “SGC had no custody over the investors’ cash or securities, the investors do not qualify as SGC ‘customers’ under the ordinary operation of the statutory definition” the Court concluded.
The SEC argued, however, that given the interrelation of the Stanford operations, funds deposited with SIBL should be viewed as effectively on deposit with SGC – the entities should be viewed as one. This theory is grounded on the bankruptcy doctrine of “substantive consolidation” which, under equitable principles, would view the entities as one. Even assuming this is correct, the Court held, it does not support the position of the SEC since the CDs are a contractual investment in the entity which added to the capital of SIBL. Such instruments are excluded from coverage under the Act. While the plight of these investors is unfortunate, the Court noted, they are not covered by the statute.
Unauthorized transactions: The Australian Securities & Investment Commission banned financial adviser Adam David Joyner from providing financial services. The regulator found that Mr. Joyner had used client funds for purposes other than as instructed, had failed to implement trades and tried to cover-up his conduct. He caused client losses of over $1 million.
Investment fund fraud: Criminal charges were initiated against Frederick L. Hansen, formerly a director of Global Rule Pty Ltd, following an investigation by the ASIC. The agency had a receiver appointed for the company and found that Global Rule had raised about $16.3 million from 170 investors with promises of returns at 21.6% from early 2009 to the fall of 2010. Mr. Hansen is facing criminal charges which carry a maximum of 12 years in prison.
Misappropriation: The Securities and Futures Commission revoked the licenses of Union Securities Limited and its two responsible officers, Ma Kin Chung and Cheng Tai Ha. The two individuals were also banned for life from the securities business. The action is based on the misappropriation of $400,000 from two clients who deposited funds with the firm for securities trading. Both individuals have fled Hong Kong.
Manipulation: The SFC secured the conviction of registered representative Wong Pok Wang on 13 counts of manipulating the indicative equilibrium price or IED for eight derivate warrants and callable bull/bear contracts during the pre-opening session. The conduct took place from October 2010 to February 2011.
Asset freeze: The SFC obtained an injunction and freeze order over 107,290,000 shares of Hisense Kelson Electrical Holdings Ltd., up to a sum of $1.2 billion. The shares were held by, or for the benefit of Gu Chujun, the former chairman and CEO of Greencool Technologies Holdings Ltd. Hisense was an exchange listed company. The action is based on market misconduct by Mr. Chujun.
Corruption: The Serious Frauds Office charged Alstom Network UK Ltd. with three offenses of corruption. The charges are based on actions which took place from June 2000 to November 2006. They concern large transport projects in India, Poland and Tunisia. The investigation began with a report from the Attorney General in Switzerland concerning the Alstom Group.
Corruption: The SFO announced that Bruce Hall, formerly the CEO of Aluminium Bahrain B.S.C. or Alba, was sentenced to serve 16 months in prison on a charge of conspiracy to corrupt. The charges stem from his receipt from 2002 to 2005 of about £2.9 million in corrupt payments in connection with allowing a corrupt arrangement to continue in which Sheikh Isa bin Ali Al Khalifa, a member of the royal family, had been involved. Mr. Hall also has to pay a related confiscation order of over £3 million within seven days or face serving an additional term of 10 years in prison. His sentence was reduced for cooperation. U.S. enforcement authorities brought a related FCPA actions which resulted in payments that put the case at number 5 in the top ten largest FCPA settlements. U.S. v. Alcoa World Alumina LLC (W.D. Pa. Jan. 9, 2014); In the Matter of Alcoa, Inc., Adm. Proc. File No. 3-15673 (January 9, 2014).
Supervision: The Financial Conduct Authority used its suspension power for the first time, banning two subsidiaries of the Financial Group Limited from recruiting new appointed representatives and individual advisers for a period of four and a half months. The FCA found that from August 2008 through April 2013 the firm had a systematic weakness in the design and execution of its systems and controls and risk management framework. These failings were directly attributable to the firm’s cultural focus.
Investment fund scheme: The FCA commenced a criminal proceeding against Phillip Harold Boakes for 13 alleged offences related to an unauthorized forex investment scheme that took place between October 2004 and June 2013. The charges include fraud and theft.
July 23, 2014
The SEC filed a settled insider trading case against a partner in an investor relations firm who traded securities based on information he obtained from draft press releases he worked on for firm clients. The settled action alleges that the executive was a “temporary” insider and breached a duty to his firm. It was resolved with a conduct based injunction and monetary payments. SEC v. McGrath, Civil Action No. 14 CV 5483 (S.D.N.Y. Filed July 22, 2014).
Kevin McGrath has been with Cameron Associates since 1996 and a partner since 2003. Previously, he worked for an investment advisory firm and had been a registered representative.
Cameron is an investor relations firm whose clients are primarily small, publicly traded companies. Two of its clients are Misonix, Inc. and Clean Diesel Technologies, Inc. Misonix, a developer and manufacturer of medical devices and laboratory equipment, became a firm client in 2008. Clean Diesel, a global manufacturer of emissions and control systems and products, became a firm client at the end of 2010.
Mr. McGrath worked on a number of press releases for Misonix. In April 2009 he purchased 10,000 shares of Misonix stock. Later that same month he began communicating with the company on an Earnings Release.
On May 6, 2009 Mr. McGrath sent an e-mail to a Misonix employee regarding the date the Release would be issued. He was told that it would be issued in May. The next morning he received a draft of the Release. The drafts stated that the company had significant declines in revenue from the prior nine-month period. A comment by the CEO stated that difficult times were ahead. Later that afternoon a Misonix employee confirmed in an e-mail to the executive that the Release would be finalized on Friday, the next day. About forty minutes later Mr. McGrath sold all of his Misonix shares.
On Monday Mr. McGrath submitted the Release to the PR Newswire for issuance. By the time of the market close the stock price had dropped 36%. By selling his shares the prior week Mr. McGrath avoided losses of $5,400.
Mr. McGrath began providing investor relations services to Clean Diesel in January 2011. He frequently received non-public information from the firm.
In May 2011 Mr. McGrath was involved in drafting a May 25 release in which the company announced it had received a significant amount of orders in connection with a recently announced program by the State of California. On May 24, 2011 a Clean Diesel employee sent Mr. McGrath an e-mail stating that the release would be issued the next day. Fourteen minutes later the account executive purchased 1,000 shares of Clean Diesel.
The next day the release was issued after the close of the market. By the close of the market on the following day the share price had increased about 95%. Mr. McGrath sold his shares, realizing profits of $6,376.
The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Mr. McGrath resolved the matter, consenting to the entry of a “conduct-based injunction” which prohibits future violations of the Sections cited in the complaint. It also permanently requires Mr. McGrath to abstain from trading in the stock of any issuer for which he or his firm has performed any investor relations services within a one year period. His employer is also required to provide written notice to a client upon any intent to sell shares received as compensation for services performed and must receive written authorization for the sale from the company management. In addition, he agreed to pay disgorgement of $11,776, prejudgment interest and a penalty equal to the amount of the disgorgement. See Lit. Rel. No. 23049 (July 22, 2014).
July 22, 2014
For former Qualcomm Inc. Executive Vice President Jing Wang the cover-up not only failed but increased his liability. The former executive pleaded guilty this week to securities fraud based on his insider trading, money laundering tied to his efforts to evade detection and admitted to obstruction. U.S. v. Wang, 3:13-cr-03487(C.D. Calif. Filed Sept. 20, 2013).
Mr. Wang traded on inside information obtained from his employer in three instances. First, on March 1, 2010, after the close of the market, Qualcomm announced an increase in its dividend and a stock repurchase plan. Earlier, in February Mr. Wang became aware of these plans. On the morning of March 1, he attended a company board meeting where the plan was discussed. Later that day he instructed his friend and broker Gary Yin, a registered representative at Merrill Lynch, to use all of the funds in an account he controlled to purchase Qualcomm shares. Mr. Yin also purchased shares. After the announcement the share price increased and both men sold the securities at a profit.
Second, on January 5, 2011 Qualcomm announced the acquisition of Atheros Communications, Inc. Prior to the announcement Mr. Wang learned about the deal through the course of his duties. He also attended a board meeting where it was discussed. He purchased shares of Atheros as did Mr. Yin. After the announcement the share price increased and both men sold their shares at a profit.
Third, on January 26, 2011 Qualcomm announced increased guidance. During the prior month Mr. Wang became aware that the firm was considering announcing increased guidance. That information was confirmed at a December 6, 2010 board meeting Mr. Wang attended. The day before the announcement he telephoned Mr. Yin and instructed him to purchase company shares. After the announcement the share price increased. Mr. Wang sold all of his shares at a profit.
The cover-up traces to 2006 before the insider trading. In that time period Messrs. Wang and Yin created off-shore entities and set-up accounts. The ownership of the accounts was designed to make it appear that they belonged to others. The money laundering charge was based on the efforts of Mr. Wang to transfer over $525,000 from one of the offshore accounts that included about $250,000 from the insider trading to another nominee brokerage account in the British Virgin Islands. As part of the plea agreement Mr. Wang also admitted to fabricating evidence and a false cover story in conjunction with his brother Bing Wang and Mr. Yin.
Previously, Gary Yin pleaded guilty to conspiring with Jing Wang and Bing Wang to obstruct justice and launder money. His sentencing is scheduled for September 15, 2014. Bing Wang was also indicted. He is believed to be in China. Mr. Wang’s sentencing has not been scheduled. See also SEC v. Wang, Civil Action No. 3:13-cv-02270(S.D. Cal. Filed Sept. 23, 2013).
July 21, 2014
The D.C. Circuit rejected efforts by the SEC to compel the Securities Investor Protection Corporation to liquidate a broker-dealer that was part of the Stanford Ponzi scheme empire. The investors had purchased CDs from an off-shore Stanford entity. The Circuit Court affirmed the decision of the District Court. SEC v. SIPC, No. 12-5286 (D.C. Cir. Decided July 18, 2014).
The case arose out of the massive financial fraud authored by Robert Allen Stanford. At the center of the scheme the SEC has called a Ponzi scheme, was a complex web of entities. Two are involved here. One is the Stanford International Bank, Ltd. or SIBL, a bank organized under Antiguan law. It sold debt assets that promised a fixed rate of return. The second is Stanford Group Company or SGC, a Huston-based broker-dealer registered with the SEC.
To purchase a CD, investors had to open an account with SIBL, according to the factual record which was largely stipulated. CD purchasers paid the bank for the instruments. The U.S. disclosure statements stated that SIPIC did not provide coverage for the CDs.
In 2009 the SEC brought a civil enforcement action against Mr. Stanford, SGC, SIBL and others. The court appointed a receiver for SGC and other entities. The receiver concluded that the bank had outstanding about $7.2 billion in CDs. The receiver asked SIPC to determine if it would liquidate SGC to protect the assets of those who had purchased CDs from SIBL. SIPIC determined that those investors were not covered. Eventually, the SEC prevailed in its case and imposed a $6 billion civil penalty. Mr. Stanford was convicted on criminal charges and sentenced to serve 110 years in prison. Antiguan authorities initiated separate proceedings to liquidate SIBL and process claims. Other civil litigation was initiated.
Two years later the SEC concluded SIPIC was wrong as to the SIBL issued CDs. It filed an application with the District Court to compel SIPC to commence liquidation proceedings. SIPIC declined. The District Court concluded that SIPIC was correct in determining that the CD purchasers were not customers within the meaning of the Act, a prerequisite to coverage. The District Court rejected the request for an order to compel SIPIC.
The critical question here, according to the Circuit Court, is whether those who purchased SIBL CDs at the suggestion of the broker-dealer are customers for purposes of the Securities Investor Protection Act. That Act, passed in 1970, created SIPIC to provide relief to customers of failing broker-dealers. When a SIPC member firm is in financial difficulty the non-profit corporation can initiate a liquidation proceeding in which a trustee can be appointed to oversee the liquidation of the firm after removal to bankruptcy court. The trustee is to return any customer cash and securities on deposit with the broker. If there are insufficient funds, SIPIC must cover the shortfall up to certain limits. The SEC has plenary authority to supervise SIPIC.
The Securities Investor Protection Act focuses on the custody function of brokers. It provides coverage for customer funds and securities held on deposit with the broker which, prior to the Act, were often depleted in the liquidation of the firm. The Act generally affords no protection against other types of losses.
A customer is generally defined as a person who has deposited cash with the broker for the purpose of purchasing securities. A claimant must generally demonstrate that the broker received or held the claimant’s property and that the transaction gave rise to the claim and contained the indicia of a fiduciary relationship between the customer and the broker.
In this case the purchasers of SIBL CDs are not customers within the meaning of the Act, the Court held. It is undisputed that the investors did not deposit cash with SGC. Since “SGC had no custody over the investors’ cash or securities, the investors do not qualify as SGC ‘customers’ under the ordinary operation of the statutory definition” the Court concluded.
The SEC argued, however, that given the interrelation of the Stanford entities, funds deposited with SIBL should be viewed as effectively on deposit with SGC – the entities should be viewed as one. This theory is grounded on the bankruptcy doctrine of “substantive consolidation” which, under equitable principles, would view the entities as one.
While that doctrine may be applicable here, it does not support the SEC’s contention. The SIPIC statute excludes from coverage investments in the debtor which add to its capital, the Court stated. Thus, even if the entities are viewed as one, since the CDs are a contractual investment in the entity which added to the capital of SIBL, they are excluded. While the SEC attempted to side-step this result by arguing that the CD proceeds became part of the capital of SIBL and not the broker dealer, if the entities are merged the funds become part of the capital of the merged entity.
Finally, in its reply brief the SEC claimed for the first time that funds given to a consolidated entity for the CDs should not become part of the entity’s capital because they were part of a Ponzi scheme. The SEC offered no authority for this contention which was rejected by the Court. The fact is the CD purchasers acted as lenders which are not covered. While the plight of these investors is unfortunate, the Court noted, they are not covered by the statute.
July 20, 2014
Microcap fraud is a continuing enforcement priority for the SEC. Last week, for example, the Commission brought an action centered on what would have been a pump and dump scheme but for the fact that the shell company was controlled by an FBI informant and the SEC stepped in at the last moment and suspended trading.
Now the agency has brought an action centered on microcap fraud schemes tied to a repeated fraudster, SEC v. Plummer, Civil Action No. 14 CV 5441 (S.D.N.Y. Filed July 18, 2014). The action names as defendants: Christopher Plummer, the CEO of Franklin Energy and Madison & Wall Investments, LLC, who has two prior convictions for fraud based offenses and is currently serving 51 months in prison following his guilty plea to fraud charges in another, unrelated case; Lex Cowset, the CEO of CytoGenix, Inc., a microcap pharmaceutical company; and GyroGenix.
The first scheme centers on Company A and Mr. Plummer. Company A portrayed itself as a security company that used technology such as encryption software and video surveillance systems for actionable surveillance and intelligence monitoring.
In 2009 Company A announced that it would focus on renewable energy and medical testing using nanotechnology. Subsequently, the firm announced that it was also developing solar energy farms through a joint venture with Franklin Energy, a subsidiary of Franklin Power & Light LLC, a retail electricity provider purportedly operated by Mr. Plummer. The joint venture was to build, own and operate solar energy farms across the United States beginning as early as the latter part of 2010.
A series of press releases and web site postings were made touting Company A and the potential of the joint venture. In fact neither Franklin nor Company A had the resources that were claimed in the press releases. There were no resources to implement the plans of the joint venture. Nevertheless, the press releases and web postings had a significant market impact, according to the complaint.
A second scheme involved CytoGenix. Prior to its affiliation with Mr. Plummer the company held it self out to be a developer of biotechnology derived products for vaccines and therapeutic applications for human, agricultural and veterinary markets. In 2010 Mr. Plumber approached the firm about a partnership with Franklin. After Mr. Cowsert agreed a press release dated August 16, 2010 was issued. It announced the formation of a company subsidiary called BioEnergy that would operate as a joint venture partner with Franklin. The venture would be run by Mr. Plumber. Its purpose was to identify, evaluate and develop biologically based technologies for energy production.
In the Fall of 2010 CytoGenix sold private placement shares tied to its partnership with Franklin. About $330,000 was raised through this offering. Investors were told the funds would be used to help develop the joint venture.
In fact the claims about the venture and the entities were false. CytoGenix was financially distressed, having lost all its intellectual property in an earlier litigation, contrary to representations made in press releases about the firm. Franklin was essentially a sham, also contrary to representations made about the company. And, the proceedings of the offering were not used for the purpose told to investors. Indeed, no shares were ever issued to investors and Messrs. Plummer and Cowsert misappropriated the funds. The Commission suspended trading in the shares of CytoGenix in 2011.
The complaint alleges violations of Exchange Act Sections 10(b) and 20(b) and Securities Act Section 17(a). The case is in litigation. See Lit. Rel. No. 23047 (July 18, 2014).
July 17, 2014
The SEC’s insider trading probe regarding the House Ways and Means Committee and a senior staff member, also involves 44 investment funds and other entities, according to a Bloomberg news report citing recently filed court papers. The investigation is on-going.
The Commission suffered another courtroom loss. This time the agency lost an insider trading claim brought in the Wyly case which was tried to the court after a jury found in favor of the SEC on other claims involving the concealment of the brothers’ shareholdings.
This week the SEC filed an insider trading action centered on a golf group, two stock manipulation cases and a group of actions centered on a claim that the identity of the real control persons of an issuer was concealed in view of their prior law enforcement difficulties. A settled action alleging that EY violated the auditor independence rules was also filed.
Remarks: Commissioner Michael S. Piwowar addressed the AEI Conference on Financial Stability, Washington, D.C. (July 15, 2014). His remarks focused on the FSOC and his concerns that the organization and some of its members are encroaching on the Commission’s area (here).
Commissioner Scott D. O’Malia addressed the Quadrilateral Meeting of the European Financial Markets Lawyers Group, Financial Law Board, Financial Markets Law Committee and Financial Markets Lawyers Group at the Federal Reserve Bank of New York in remarks titled Regulators Must First Do No Harm (July 15, 2015). His remarks focused on fragmented markets, arguing for a holistic approach (here).
SEC Enforcement – Litigated Actions
Insider trading: SEC v. Wyly, Civil Action No. 10-cv-5760 (S.D. N.Y.) is an action in which the SEC prevailed on fraud claims presented to the jury. The agency lost on its insider trading claim which was tried to the court because the penalty was time barred. The claim centered on arrangements to sell Sterling Commerce in the Fall of 1999 and the idea of the Wyly brothers from the summer of that year that they would sell Sterling Commerce and Sterling Software. Between 1992 and 1996 Sam and Charles Wyly created a number of IOM trusts which typically followed their investment recommendations. The brothers had also co-founded Sterling Software in 1981 which later spun off its electronic commerce division which became Sterling Commerce. Both brothers continued as board members for each company.
In September 1999 there were discussions about taking a long position in Sterling Software among advisors to the brothers. Through a series of complex transactions in October 1999 the trusts owned the equivalent of 2 million shares of Sterling Software.
During the summer of 1999 Sam Wyly decided he wanted to sell both Sterling Software and Sterling Commerce. It was his belief that the tech area had reached “euphoric proportions.” No significant steps were taken to sell Sterling Software until November 1999, after which it merged with Computer Associates. In contrast, there were significant efforts to sell Sterling Commerce dating to the Summer 1999, including retaining an investment bank.
The insider trading claim, however, was tied to the sale of Sterling Software and the stock purchases. The agency argued that at the time of the securities acquisitions in October 1999 the Wylys were in possession of material non-public information. Specifically, the SEC claimed that “as Chairman and vice-Chairman of Sterling Software . . . [they] had agreed and resolved that the sale of Sterling Software to an external buyer should be pursued.” Stated differently, the brothers had an idea. The Court rejected this claim, concluding as a matter of law that the information was not material and thus could not be the predicate for an insider trading claim.
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed, or announced the filing of, 3 civil injunctive actions, DPAs, NPAs or reports and 5 administrative proceedings (excluding follow-on and Section 12(j) proceedings).
Manipulation: SEC v. Discala, Civil Action No. CV 14-4346 (E.D.N.Y. Filed July 17, 2014) is an action against Abraxas Discala and Marc Wexler, respectively, the CEO and president of merchant bank OmniView Capital Advisors LLC; Matthew Bell and Craig Josephberg, registered representatives at a broker; and Ira Shapiro, CEO of CodeSmart Holdings, Inc., a firm created from a reverse merger with minimal assets and a loss from operations. The case centers on a pump and dump scheme in which a substantial number of shares were dumped in the market, the price of the stock was inflated to about $4.60 giving the shell a market capitalization of over $86 million and then the stock was dumped with the price crashing to about 10 cents. Messrs. Discala and Wexler reaped millions of dollars while Messrs. Bell and Josephberg made over $500,00. The Commission’s complaint alleges violations of Exchange Act Sections 9(a) and 10(b), Securities Act Sections 5(a) and (c) and each subsection of Section 17(a). The case is pending. Parallel criminal charges were brought. See Lit. Rel. No. 23046 (July 17, 2014).
Diversion of funds: In the Matter of Lakeside Capital Management, LLC, Adm. Proc. File No. 3-15976 (July 17, 2014) is a proceeding naming as respondents the registered investment adviser and its owner and portfolio manager, Dennis H. Daugs, Jr. From 2008 through 2012 Mr. Daugs diverted over $8 million in client assets to his use. First he invested $3.1 million of a client’s funds in a loan to himself. Second, he used over $560,000 from a private fund to make settlement payments to several of his clients. The funds were eventually repaid. The Order alleges violations Exchange Act Section 10(b) and Advisers Act Sections 206(1), (2) and (4). The Respondents resolved the action, with each consenting to the entry of a cease and desist order based on the Sections cited in the Order. Mr. Daugs was barred from the securities business with a right to reapply after five years. Respondents, jointly and severally, will also pay disgorgement of $302,451, prejudgment interest and a civil penalty of $250,000.
Misappropriation: SEC v. Pearson, Civil Action No. 1:14-cv-03875 (N.D. Ill.) is a previously filed action against Robert Pearson and Illinois Stock Transfer Company from which he misappropriated about $1.3 million. The defendants consented to the entry of a permanent injunctions prohibiting future violations of Exchange Act Sections 10(b) and 17A(d)(1). Issues concerning disgorgement and penalties will be decided in the future on motion by the Commission. See, Lit. Rel. No. 23043 (July 11, 2014).
Concealed control: In the Matter of Natural Blue Resources, Inc. Adm. Proc. File No. 3-15974 (July 16, 2014); In the Matter of Erik H. Perry, Adm. Proc. File No. 3-15975 (July 18, 2014); In the Matter of Toney Anaya, Adm. Proc. File No. 3-15973 (July 16, 2014). This is a group of proceedings center on OTC traded Natural Blue, an issuer which filed reports with the SEC. The proceeding against the company also names as Respondents James Cohen and Joseph Corazzi. Messrs. Cohen and Corazzi created the company. Each had a consulting agreement. From August 2009 through late January 2011 Mr. Anaya was the CEO of the company after which Mr. Perry assumed that role. In fact Messrs. Cohen and Corazzi secretly ran the company. Both had backgrounds which included violations of the law for fraud. Investors were thus not told who was running the company, which also maintained a website that contained false statements. The Order as to the company and Messrs. Cohen and Corazzi alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(d). That case will be set for hearing. The proceeding as to Mr. Anaya alleges violations of Securities Act Section 17(a)(2). Mr. Anaya entered into a cooperation agreement with the SEC. He also consented to the entry of a cease and desist order based on the Section cited in the Order. He was barred from participating in any penny stock offering with a right to apply for reentry after five years. A hearing will be held to determine any monetary sanctions. The proceeding against Mr. Perry alleged violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Mr. Perry resolved the action, consenting to the entry of a cease and desist order based on the Sections cited in the Order. Mr. Perry was also barred from serving as an office or director of a public company and participating in a penny stock offering. In addition, he was directed to pay a penalty of $150,000.
Investment fund fraud: SEC v. Rooney, Civil Action No. 11-8264 (N.D. IL.) is a previously filed action brought against Patrick Rooney and his controlled entity, Solaris Management, LLC. The complaint alleged that the defendants radically changed the investments of the managed fund, contrary to its documents, by becoming wholly invested in a financially troubled company of which Mr. Rooney was chairman. Previously, the defendants settled, agreeing to the entry of consent injunctions based on Securities Act Section 17(a), Advisers Act Sections 206(1) and (2) and Exchange Act Sections 10(b) and 13(d). This week the Court entered an order requiring the defendants to pay disgorgement of $715,700, prejudgment interest and a civil penalty equal to the disgorgement. Mr. Rooney was also barred from operating a private investment fund and serving as an officer or director of any public company except the one involved here since he is CEO and Chairman. See Lit. Rel. No. 23045 (July 16, 2014).
Independence: In the Matter of Ernst & Young, Adm. Proc. File No. 3-15970 (July 14, 2014). In 2000 EY acquired Washington Counsel, P.C., a legislative advisory services provider. In 2009 EY, through Washington Counsel, provided legislative advisor services for Firm A and Firm B. For example, for Firm A Washington Counsel urged the passage of legislation to congressional staff on behalf of the client on two different occasions. For Firm B on one occasion the advisory firm attempted to persuade congressional offices to withdraw support for a proposal that would have been detrimental to the client. In both instances Washington Counsel acted as an advocate for the Firms. Both Firms were audit clients of E&Y. At the time EY had issued audit opinions for each Firm, representing that it was independent despite the fact that the audit firm was not since it was acting as an advocate for each client. The Order alleges violations of the independence rules. Specifically, it alleges violations of Rule 2-02(b)(1) of Regulation S-X. It also alleges that the audit firm caused violations of Exchange Act Section 13(a) and Rule 13a-1 by the two audit clients. To resolve the proceeding EY consented to the entry of a cease and desist order based on the provisions cited in the Order and to a censure. The firm also agreed to pay disgorgement of $1,240,000, prejudgment interest and a civil penalty of $2,480,000.
Insider trading: SEC v. McPhail, Civil Action No. 1:14-cv-12958 (D. Mass Filed July 11, 2014) names as defendants Eric McPhail and a group of his friends, Douglas Parigian, John Gilmartin, Douglas Clapp, James “Andy” Drohen, John Drohen and Jamie Meadows. Mr. McPhail became close friends with an Executive at American Superconductor through their country club. The two men frequently played golf together and socialized. Over time they became close and shared confidences with the understanding that the information would be kept confidential. Beginning in July 2009 Mr. McPhail periodically obtained inside information from his friend the Executive. He circulated that to his other friends through e-mail. Mr. McPhail and various of his friends repeatedly traded on the information. The complaint alleges violations of Exchange Act Section 10(b). Messrs. Gilmartin, Clapp, Andy Drohen and John Drohen settled with the Commission, with each consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b). In addition, each paid disgorgement, prejudgment interest and a civil penalty equal to their trading profits: Mr. Gilmartin $23,713 in disgorgement; Mr. Clapp, $11,848 in disgorgement; Andy Drohen $22,543 in disgorgement; and John Drohen $8,972 in disgorgement. See Lit. Rel. No. 23040 (July 11, 2014).
Manipulation: SEC v. Affa, Civil Action No. 1:14-cv-12959 (D. Mass. Filed July 11, 2014) names as defendants Michael Affa, Andrew Affa, Mitchell Brown, Christopher Putnam and Christopher Nix. The scheme centers on trading in the shares of Amogear Inc. in the over-the-counter markets beginning in August 2012. Amogear is a shell which has no business operations. During the period it was controlled by a Confidential FBI Informant. At one point the CFO of the company was an undercover FBI agent. Messrs. Nix and Putnam put together a scheme to manipulate the stock price and trading of Amogear. Mr. Nix owned a promotional firm called Global Marketing Media LLC and websites that touted and promoted penny stocks. Messrs. Nix and Putnam planned a promotional campaign for Amogear shares. The plan was to run a pump and dump scheme. Various defendants had specific roles such as manipulative trading. The defendants and the Confidential Informant agreed that the scheme would kick-off in early February 2014. On the kick-off date the websites controlled by Global Marketing Media released e-mail blasts containing misrepresentations about the company. On the same date the Commission suspended trading in the shares of the company. The Commission’s complaint alleges violations of Exchange Act Section 10(b) and Securities Act Sections 17(a)(1) and (3). The action is in litigation. Parallel criminal charges were brought by the U.S. Attorney’s Office.
Prime bank fraud: SEC v. Butts, Civil Action No. 13-23115 (S.D. Fla.) is a previously filed action against, among others, attorney Bernard H. Butts who served as the escrow agent for the scheme. The Court entered an order directing Mr. Butts to pay disgorgement of $1,691,608, prejudgment interest and a penalty of $2,059,284.19. Mr. Butts also consented to the entry of an order barring him from the securities business, from participating in any penny stock offering and suspending him from practicing as an attorney on behalf of any entity regulated by the SEC. See Lit. Rel. No. 23044 (July 15, 2014).
U.S. v. Pomponi (D. Conn.) is an action in which William Pomponi, formerly vice president of regional sales at Alstom Power Inc., pleaded guilty to a criminal information charging conspiracy to violate the FCPA in connection with the awarding of the Tarahan power project in Indonesia. In the underlying scheme the defendant, and others, paid bribes to officials in Indonesia, including a member of Parliament and high-ranking members of Perusahaan Listrik Negara or PLN, the state owned and controlled electricity company, in exchange for assistance in securing a $118 million contract known as the Tarahan project to provide power related services. Mr. Pomponi is the fourth Alstrom executive to plead guilty.
July 16, 2014
Auditor independence is critical. The opinion issued by the audit firm regarding the financial statements of an audit client represents in part that the firm is independent. That judgment is based on an assessment of all the facts and circumstances of the relationship involving the audit firm and the issuer under SEC precedent. Thus, for example, the Commission has stated that if the relationship places the accountant in a position of being an advocate for an audit client, the firm is not independent.
Yet this precisely what EY did with regard to two audit clients – act as an advocate. In the Matter of Ernst & Young, Adm. Proc. File No. 3-15970 (July 14, 2014). In 2000 EY acquired Washington Counsel, P.C., a legislative advisory services provider. In 2009 EY, through Washington Counsel, provided legislative advisor services for Firm A and Firm B. For example, for Firm A Washington Counsel urged the passage of legislation to congressional staff on behalf of the client on two different occasions.
Washington Counsel also provided legislative advisory services for Firm B. For example, on one occasion the advisory firm attempted to persuade congressional offices to withdraw support for a proposal that would have been detrimental to the client.
In both instances Washington Counsel acted as an advocate for the Firm A and Firm B. Both firms were audit clients of E&Y. At the time EY had issued audit opinions for each firm represented that it was independent despite the fact that is was not since the firm was acting as an advocate for each client.
At the time of the violations “EY issued a written independence policy intended to provide guidance on the provision of legislative advisory services to audit clients,” according to the Order. The Order states that EY did not provide formal, in-person training “specifically tailored to the policy.” It does not specify that the policy was violated by the conduct involved here.
The Order alleges violations of the independence rules. Specifically, it alleges violations of Rule 2-02(b)(1) of Regulation S-X. It also alleges that the audit firm caused violations of Exchange Act Section 13(a) and Rule 13a-1 by the two audit clients.
In resolving the proceeding the Commission took into account the cooperation of EY and its remedial acts which included the issuance of “new guidance restricting such legislative advisory services.”
To resolve the proceeding EY consented to the entry of a cease and desist order based on the provisions cited in the Order and to a censure. The firm also agreed to pay disgorgement of $1,240,000, prejudgment interest and a civil penalty of $2,480,000.
July 15, 2014
The SEC got a much needed courtroom win with a jury verdict in the Wyly case. The insider trading claim, however, was not submitted to the jury because any penalty was time barred. That claim, which was little more than the “personal desires” of the brothers was rejected by the Court which concluded that the Commission’s theory of materiality would “impermissibly broaden civil and criminal insider trading liability and potentially extend the reach of other securities laws . . .” SEC v. Wyly, Civil Action No. 10-cv-5760 (S.D. N.Y. Opinion issued July 11, 2014).
The claim centered on arrangements to sell Sterling Commerce in the Fall of 1999 and the idea of the Wyly brothers from the summer of that year that they would sell Sterling Commerce and Sterling Software. Between 1992 and 1996 Sam and Charles Wyly created a number of IOM trusts, each of which owned several subsidiary companies. Employees of the Wyly Family Office served as protectors of the trusts. The Wylys’ investment recommendations were communicated to the trusts and most, if not all, were implemented.
The Wyly brothers had also co-founded Sterling Software in 1981. Fifteen years later that company spun off its electronic commerce division which became Sterling Commerce. Both brothers continued as board members for each company.
In September 1999 there were discussions about taking a long position in Sterling Software among advisors to the brothers. While there was some dispute as to whether one of the brothers or others originated the idea, in October the first step to implement it was taken. Three of the trusts entered into the first swap agreements with Lehman Brothers as the counterparty. The transactions reference 1.5 million shares of Sterling Software. Additional, similar agreements were entered into involving other trusts. In the end the swap agreements, with a notional value of over $30 million, became the functional equivalent of the IOM entities purchasing 2 million shares of Sterling Software stock on the open market in October 1999.
During the summer of 1999 Sam Wyly decided he wanted to sell both Sterling Software and Sterling Commerce. It was his belief that the that the tech area had reached “euphoric proportions.”
No significant steps were taken to sell Sterling Software until November 1999, after which it merged with Computer Associates. In contrast, there were significant efforts to sell Sterling Commerce dating to the Summer 1999. In late summer Goldman Sachs was contacted about a possible sale of Sterling Commerce. On September 15, 1999 the board of that company considered the possibility and later that month formally retained the investment banker for “strategic third party transaction alternatives.”
The insider trading claim, however, was tied to the sale of Sterling Software and the stock purchases. The agency argued that at the time of the swap agreements in October 1999 the Wylys were in possession of material non-public information. Specifically, the SEC claimed that “as Chairman and vice-Chairman of Sterling Software . . . [they] had agreed and resolved that the sale of Sterling Software to an external buyer should be pursued.” Stated differently, the brothers had an idea. The Court rejected this claim, concluding as a matter of law that the information was not material and thus could not be the predicate for an insider trading claim.
Materiality in this context is not based on a bright line test. Nor is a fact material simply because a reasonable investor would like to know it. Rather “it requires a balancing between the probability of a future event and its potential impact . . .” Judge Scheindlin held. In this context it means that “something beyond desire to transact is necessary.”
Here there is no evidence that the Wylys approached any third party such as an investment banker or a potential buyer about selling Sterling Software before entering into the swap transactions in October. Goldman Sachs was retained by Sterling Commerce, but there is no evidence that the firm was asked to work on a transaction for Sterling Software. While the SEC claimed that the sale of Sterling Commerce cannot be separated from a sale of Sterling Software, there is nothing to suggest that the sale of one company was contingent on a sale of the other.
Likewise, the fact that in late October the Sterling Software board entered into a change of control agreement does not support the SEC’s theory. At best, the Court found, the agreement confirmed the desire of the Wyly brothers to sell. But the agreement did not change the probabilities about entering into a transaction.
Finally, while the SEC is correct, the Court noted, that the huge equity swaps were the first transactions of that kind in which the brothers were involved, the fact does not support its claim. It is clear that the brothers had made large investments before. In the end, while the agency argued that the application of existing law supported its claim that the brothers engaged in insider trading, the Court disagreed, concluding that the Commission was seeking an unprecedented expansion of the law on a record where there is “no evidence that the Wylys acted to exert . . . [their] control to pursue a sale before November 1999.”