As the holiday weekend which traditionally signals the end of the summer approaches, the SEC settled with a defendant in a long running financial fraud case, filed a settled insider trading case, brought more investment fund cases and filed two more settled actions relating to the financial fraud at Dell Inc. Perhaps the most noteworthy action is the Moody’s Section 21(a) Report giving a preview of the impact of Dodd-Frank on the enforcement program.

SEC enforcement actions

Financial fraud: SEC v. Lucent Technologies, Inc., Civil Action No. 04-2315 (D.N.J.) is a long running financial fraud case based on improperly recording revenue since there were side deals and similar arrangements which should have precluded recognition as discussed here. Defendant, Nina Aversano, former President of North American Service Provider Networks and former corporate officer of Lucent settled. Ms. Aversano consented to the entry of a permanent injunction prohibiting her from aiding and abetting future violations of the antifraud provisions of the federal securities laws and from violating or aiding and abetting violations of the books and records, internal controls, and reporting provisions. She also agreed to pay a civil penalty of $100,000, not to seek or become an officer or director of a public company for one year, to resign from an audit committee position she held and to discontinue her relationship with the board of directors of New Jersey Resources at the earlier of either her termination by the company or the end of her term. See Litig. Rel. 21639 (Sept. 1, 2010).

Investment fund fraud: SEC v. Venetis, Civil Action No. 10-cv-4493 (D.N.J. Filed Sept. 2, 2010) is an action against investment adviser Sandra Venetis and her controlled entities, Systematic Financial Services, Inc., Systematic Financial Associates, Inc. and Systematic Financial Services, LLC. The complaint alleges that since 1997 the defendants have raised at least $11 million from investors through the sale of promissory notes. Investors were told that the notes were either backed by the FDIC and paid six to eleven percent per year and were tax free or were backed by Medicare reimbursement payments. The claims were false. The funds went to the defendants. The complaint alleges violations of Securities Act Sections 5 and 17(a), Exchange Act Section 10(b) and Adviser Act Section 206. The defendants settled, agreeing to all the relief sought in the complaint including permanent injunctions, the payment of disgorgement and financial penalties, an asset freeze and the appointment of an independent monitor. Defendants Venetis and Systematic Financial also settled related administrative actions which will bar Ms. Venetis from association with any investment adviser or broker or dealer and revoke the registration of the firm. See Litig. Rel. 21641 (Sept. 2, 2010).

Insider trading: SEC v. Self, Civil Action No. 10-cv-4430 (E.D. Pa. Filed Sept. 1, 2010) is an insider trading action against James Self Jr., the executive director at Merck & Co. , and Stephen Goldfield, an unemployed former hedge fund manager. Messrs. Self and Goldfield were friends from the time both attended an executive MBA program. On April 23, 2007 AstraZeneca acquired Medimmune, Inc. Prior to that time, the company at which Mr. Self was employed, along with 22 others, was approached by investment bankers representing Medimmune about a possible acquisition. Mr. Self was on the team at his company which reviewed the material non-public information about the deal. By mid-March 2007 Mr. Self began furnishing his friend Stephen Goldfield inside information about the deal. Mr. Goldfield, in turn, began buying options in Medimmune. When the deal was announced, he sold his holdings yielding a profit of about $13.9 million.

To settle the case, each defendant consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b). Mr. Self also agreed to pay a civil penalty of $50,000 based on his financial condition. Mr. Goldfield agreed to disgorge his trading profits along with prejudgment interest. Payment of all but $600,000 of that amount was waived based on his financial condition. See Litig. Rel. 21638 (Sept. 1, 2010).

Investment fraud: SEC v. Halek Energy, LLC, Civil Action No. 3:10-cv-01719-K (N.D. Tex. Aug. 31, 2010) names as defendants Jason Halek, two companies he controls – Halek Energy, LLC and CBO Energy, Inc. – and one of his salesmen, Christopher Wilbourn. The complaint alleges that from June 2007 through September 2009 Mr. Halek and his two companies raised about $22 million from approximately 300 investors selling investments in Texas oil and gas projects. In soliciting these sales, Mr. Halek made material misrepresentation about the risk, the use of investor funds and the returns. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b) by the defendants. It also alleges violations of Exchange Act Section 15(a) by defendant Wilbourn. Each defendant consented to the entry of a permanent injunction based on the sections cited in the complaint. Mr. Halek has also agreed to pay a $50,000 civil penalty. The SEC is pursuing disgorgement, prejudgment interest and a civil penalty against Mr. Wilbourn. See Litig. Rel. 21637 (Sept. 1, 2010).

Money laundering procedures: In the Matter of Pinnacle Capital Markets LLC, Adm. Proc. File No. 3-14026 (Sept. 1, 2010) names as respondents the broker and its president and chief compliance officer Michael Paciorek. A related action was brought by the Financial Crimes Enforcement Network or FinCEN. FinCEN Release, Sept. 1, 2010, available here. Previously, FINRA sanctioned the firm for violations of its anti-money laundering rules (discussed here).

Pinnacle is a broker dealer with over 99% of its customers outside the U.S. A large number of the corporate customer accounts that are foreign entities also have omnibus accounts some of which have sub-accounts for their own corporate or retail customers. Most of the firm’s regular and omnibus sub-account holders use direct access software to enter trades in the U.S. markets through their computers. From 2003 through November 2009, Pinnacle failed to verify information for corporate accounts in accord with its anti-money laundering procedures. It also failed to collect or verify all identifying information for most of its omnibus sub-account holders. Mr. Paciorek, as the firm’s president and chief compliance officer, directed all of the broker’s actions with respect to its customer identification procedures and the identification and verification of its customers. As a result of the foregoing failures Pinnacle was found to have willfully violated Section 17(a) of the Exchange Act and Rule 17a-8. Mr. Paciorek was the cause of those violations.

Respondents resolved the matter by consenting to the entry of a cease and desist order from committing or causing any violations and any future violations of Section 17(a) and Rule 17a-8. The firm was also censured and ordered to pay a $25,000 civil fine. FinCEN assessed a $50,000 fine against the firm. In February 2010 FINRA imposed a $300,000 fine on the firm for violating its anti-money laundering rules based in part on the facts detailed in the Commission’s Order.

Rating error: Moody’s Investors Services, Inc. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Exchange Act Release No. 62802 (Aug. 31, 2010). The Report details the cover-up of a rating error by Moody’s European operations and the Commission decision not to bring an enforcement action because of a question regarding its jurisdiction as discussed here. In the summer of 2006, Moody’s Investor Services, Inc. developed a new rating methodology for constant proportion debt obligation notes or CPDOs. In preparing and publishing the ratings the model was incorrectly set resulting in a rating that was too high. Although the company discovered the error it chose not to correct it, in part for reputational purposes, until it was disclosed in an April 2007 Financial Times article. The Commission declined to bring an enforcement action, noting that jurisdiction was questionable since the error and decision not to disclose it occurred in Europe. At the same time, the Release warns rating agencies that under Dodd-Frank the SEC has expanded jurisdiction and rating agencies are required to maintain proper internal controls and procedures.

Financial fraud: SEC v. Kamber, Civil Action No. 1:07-CV-01867 (D.D.C. Filed Oct. 17, 2007) is one of a series of actions arising out of a financial fraud at Centerpulse Ltd. This action named as a defendant Richard Jon May, the former Group VP of Finance, Tax Counsel and Treasurer of the U.S. subsidiary. The complaint alleged that Mr. May and others overstated income for the third quarter of 2002 by improperly deferring a significant expense. Fourth quarter income was also overstated from not increasing a reserve to cover about $18 million in liabilities and using anticipated refund credits to offset $5 million in expenses. To resolve the case Mr. May consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 13(b)(5) and from aiding and abetting violations of Sections 13(a), 13(b)(2)(A) & (B) and the elated rules. He also agreed to pay disgorgement of $10,519 along with prejudgment interest. In settling the case, the SEC dropped its Section 10(b) claim and the request for an officer director bar and civil penalty. See Litig. Rel. 21636 (Aug. 31, 2010).

Financial fraud: SEC v. Scahdeva (E.D. Wis. Filed August 31, 2010) is an action against Sujata Scahdeva, former principal accounting officer, secretary and vice president of finance at Koss Corporation and Julie Mulvaney, a senior accountant at the company. The complaint alleges a years long scheme during with defendant Sachdeva stole over $30 million from the company. The theft was covered up by preparing material false accounting books and records with the aid of co-defendant Mulvaney. The company restated its financial statement for fiscal years 2008, 2009 and the first quarter of fiscal 2010 following the discovery of the fraud. The Commission’s case is in litigation. See Litig. Rel. 21640 (Sept. 1, 2010). In a related criminal case Sujata Scahdeva pleaded guilty to six counts of wire fraud.

Failure to supervise: In the Matter of David V. Siegel, Adm. Proc. File No. 3-13787 (Aug. 31, 2010) is an action against David Siegel for failure to supervise Gary Gross while he was employed at Axiom Capital Management. According to the Order, Mr. Gross was hired in December 2002 when the firm established a branch in Boca Raton, Florida. Mr. Siegel was subsequently hired to manage the branch. The state of Florida required that Mr. Gross be under strict supervision because of customer complaints. Nevertheless, from early 2005 through April 2006 Mr. Gross sold millions of dollars of PIPEs to customers. Those customers were elderly, retired and risk adverse – that is, PIPEs were not suitable investments for them. During this period, Mr. Siegel failed to reasonably supervise Mr. Gross or comply with Axiom’s written supervisory procedures. Mr. Gross violated Securities Act Section 17(a) and Exchange Act Section 10(b). Mr. Siegel failed to reasonably supervise Mr. Gross within the meaning of Exchange Act Section 15(b)(4)(E) and Advisers Act Section 203. To resolve the matter, Mr. Siegel consented to the entry of an order which bars him from associating with any broker, dealer or investment adviser and requires him to disgorge $10,600 along with prejudgment interest. He was also ordered to pay a civil penalty in the amount of $15,000.

Financial fraud: SEC v. Davis, Case No. 1:10-cv-01464 (D.D.C. Filed Aug. 2, 2010); SEC v. Imhoff, Case No. 1:10-cv-01465 (D.D.C. Filed Aug. 27, 2010) are settled financial fraud cases against two former Dell Inc. employees. The former names as a defendant Robert W. Davis, Dell’s V.P. of Corporate Finance and Chief Accounting Officer. The latter names as a defendant Randall Imhoff, its Finance Director for Global I/T. The two complaints, although not identical, essentially detail a scheme to improperly boost revenues and meet street expectations beginning as early as 2001 and continuing through at least 2005. According to the complaints, discussed here, the two men improperly used various reserves to managing earnings.

Mr. Davis settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(1) & (2), Exchange Act Section 13(b)(5) and from aiding and abetting violations of Exchange Act Sections 13(a) and 13(b)(2)(A) & (B). He also agreed to disgorge $19,080 along with prejudgment interest and pay a civil fine of $175,000 and, in a related administrative proceeding, will be barred from appearing or practicing before the Commission as an accountant with a right to apply for reinstatement after five years. Mr. Imhoff consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 13(b)(5) and from aiding and abetting violations of Sections 13(a) and 13(b)(2)(A) &(B). He also agreed to disgorge $12,852 along with prejudgment interest and to pay a civil fine of $25,000. In a related administrative proceeding he will consent to the entry of an order barring him from appearing or practicing before the Commission as an accountant with a right to apply for reinstatement after three years.

Note: Each year Lexis recognizes the top twenty five corporate and securities blogs. This blog has been nominated for this honor. To vote please click here.

The anti-money laundering and customer identification rules are important market policing tools monitored by the SEC, the Financial Crimes Enforcement Network or FinCEN and FINRA. Pinnacle Capital Markets LLC, a broker dealer whose customers are largely outside the United States, was sanctioned by each regulator for violating these rules. The Commission’s action also named as a respondent Michael Paciorek, Pinnacle’s President and Chief Compliance Officer. In the Matter of Pinnacle Capital Markets LLC, Adm. Proc. File No. 3-14026 (Sept. 1, 2010); FinCEN Release, Sept. 1, 2010, available here. Previously, FINRA sanctioned the firm for violations of its anti-money laundering rules.

Pinnacle is a broker dealer based in Raleigh, North Carolina. Over 99% of the firms customers are outside the U.S. Many of those customers hold both corporate and individual accounts. A large number of the corporate customer accounts that are foreign entities also have omnibus accounts. In some instances, the foreign entities have sub-accounts for their own corporate or retail customers. Most of the firm’s regular and omnibus sub-account holders use direct access software to enter trades in the U.S. markets through their computers. Trades can thus be routed to the New York Stock Exchange and the NASDAQ system without an intermediary.

As of 2004 the firm had a documented anti-money laundering program which included a customer identification section. Exchange Act Rule 17a-8 requires broker dealers to comply with the Currency and Foreign Transactions Reporting Act of 1970 known as the Bank Secrecy Act. This includes adherence to the customer identification rules which essentially require that the broker dealer establish, document and maintain procedures for identifying and verifying the identity of customers.

From 2003 through November 2009 Pinnacle collected identifying information for its regular account holders. The firm failed, however, to verify information for corporate accounts in accord with its procedures. It also failed to collect or verify all identifying information for most of its omnibus sub-account holders. Mr. Paciorek, as the firm’s president and chief compliance officer, directed all of the broker’s actions with respect to its customer identification procedures and the identification and verification of its customers.

As a result of the foregoing failures Pinnacle willfully violated Section 17(a) of the Exchange Act and Rule 17a-8, according to the Order for Proceedings. Mr. Paciorek was the cause of those violations, the Order notes.

Respondents resolved the matter by consenting to the entry of a cease and desist order from committing or causing any violations and any future violations of Section 17(a) and Rule 17a-8. The firm was also censured and ordered to pay a $25,000 civil fine. Mr. Paciorek was not directed to pay a fine.

FinCEN assessed a $50,000 fine against the firm. FINRA, in February 2010 (discussed here), imposed a $300,000 fine on the firm for violating its anti-money laundering rules based in part on the facts detailed in the Commission’s Order and a finding that the firm failed to detect and report suspicious activity. FINRA also censured the firm and ordered it to comply with certain undertakings.

Note: Each year Lexis recognizes the top twenty five corporate and securities blogs. This blog has been nominated for this honor. To vote please click here.

The Moody’s Investors Services, Inc. Section 21(a) report released on August 31, 2010 gives an indication of the potential impact of Dodd-Frank. It is based on an existing limitation of the enforcement program, but reflects the removal of that impediment by the legislation. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: Moody’s Investors Services, Inc., Exchange Act Release No. 62802 (Aug. 31, 2010).

The Report details the cover-up of a rating error by Moody’s European operations and the Commission decision not to bring an enforcement action because of a question regarding its jurisdiction. In the summer of 2006, Moody’s Investor Services, Inc. developed a new rating methodology for constant proportion debt obligation notes or CPDOs. These are special purpose vehicles that sell unfunded CDS on corporate debt indices. The issuers use the proceeds from the notes to purchase liquid instruments which can be sold to pay CPDO issuer obligations when specific events occur.

MIS developed a new model to rate the instruments which resulted in a rating of Aaa. The instruments were marketed in Europe. Subsequently, it was determined that the metric in the rating model was inadvertently set too high. Several internal meetings were held at Moody’s Investor Services in France and the U.K. to analyze the matter. In April 2007, the rating committee voted not to downgrade the ratings for the affected notes. This decision was based in part on concerns regarding the reputation of MIS.

In May 2008 the Financial Times published an article exposing the error. Following an internal investigation, the company acknowledged it. Prior to that time however, Moody’s registered with the SEC as an NRSRO. Those papers detailed the Core Principles for the Conduct of Rating Committees. The ratings here did not adhere to those principles.

Based on these facts, the Commission declined to bring an enforcement action “[b]ecause of uncertainty regarding a jurisdictional nexus to the United States in this matter . . .” While the Release did not cite any authority on this point, clearly the Supreme Court’s decision in Morrison v. National Australia Bank Ltd., No. 08-1197 (June 24, 2010) (discussed here) delimiting the reach of Exchange Act Section 10(b) to the U.S. had an impact. Dodd-Frank however gives the Commission a predicate for warning rating agencies regarding the type of conduct detailed in the Release. The new legislation effectively overrules Morrison as to the SEC and the Department of Justice (discussed here): “The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions . . . involving ‘conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States that has a foreseeable substantial effect within the United States.’” Citing other provisions of the reform bill, the Commission also cautioned rating agencies that they are now required to maintain effective systems of controls and procedures which must be followed. For those wondering about the impact of the huge new reform bill, the Moody’s Release is a good example of its potential impact.

Note: Each year Lexis recognizes the top twenty five corporate and securities blogs. This blog has been nominated for this honor. To vote please click here.

Hedge funds were a key subject of debate during the passage of Dodd-Frank. While the funds were not tied to the causes of the market crisis, they do represent large pools of assets which can impact the market. Regulators frequently note that they have inadequate information about the funds. Accordingly, the financial reform bill contains provisions focused on registration of the funds and record keeping.

For registration, the legislation sets a minimum asset threshold for state regulated investment advisers is $100 million. If however, the adviser is not subject to registration and examination in their home state, or would be otherwise required to register with fifteen or more states, the minimum is $25 million. The Act eliminates the private investment adviser exemption. It also eliminates the intrastate exemption for advisers with any private fund client.

All registered investment advisers will be required to appoint a chief compliance officer and establish compliance programs. In addition, they must adopt a code of ethics.

The burdens of registration and inspection may be eased for mid-sized registrants. The legislation requires the SEC to issue regulations to take into account the size, governance and investment strategy of these funds. The assessment is to focus on whether these funds pose a systemic risk. The registration and examination procedures are to be designed to reflect the results of the risk assessment. Mid-sized private funds is not a defined term.

The new legislation contains a number of exemptions from registration. These include:

• Venture capital funds. The SEC has one year to define this term. These advisers will be subject to the record keeping requirements.

• Small business. Small business investment companies are exempt from registration.

• Private fund advisers. The SEC is to provide an exemption from registration for an investment adviser that serves solely private funds and has assets under management in the U.S. of less than $150 million. Private fund is defined to be any fund that would be an investment company except for the exemptions contained in Sections 3(c)(1) or 3(c)(7) of the Investment Company Act.

• Family offices. Generally family offices are placed outside the Investment Advisers Act. The SEC is required to define the term taking into account several factors stated in the Act.

• Foreign private adviser. The legislation exempts from registration an investment adviser who: 1) has no place of business in the U.S.; 2) has fewer than fifteen clients and investors in the U.S. in private funds; and 3) has aggregate assets under management attributable to clients and investors in the U.S. in private funds of less than $25 million. The SEC is given authority to the dollar amount in the last requirement.

• CFTC registration. Generally, investment advisers registered with the CFTC as commodity trading advisers that advise private funds are exempt.

The legislation gives the SEC authority to conduct periodic inspections of private funds and review all of their records. The Commission is also authorized to conduct special examinations as it deems necessary. In addition, advisers are required to maintain specific records including those regarding: 1) the amount of assets under management, 2) the type of assets held; 3) the use of leverage; 4) counterparty exposure; 5) trading and investment positions; 6) valuation policies and practices; and 7) those deemed necessary by the SEC in consultation with the Counsel created by the Act. The Act requires certain information to be shared with the Council, although proprietary information is subject to enhanced confidentiality measures.

The SEC is required to report to Congress annually on the uses made of the data collected from registered advisers to monitor the markets for the protection of investors and the markets. The SEC and CFTC are also required, within one year, to have consulted with the Council and jointly issue rules regarding the form and content of reports to be filed with each agency by advisers registered with each. The provisions of this section of the Act are generally effective within one year.

Finally, as in other sections of the legislation, it directs that four studies be undertaken:

• Within one year the SEC must submit a study on the feasibility, benefits and costs of requiring the reporting of short sale positions in real time to the public or, alternatively only to the SEC and FINRA. The study is also to include a voluntary pilot program in which companies agree to have trades in their shares marked “short,” “market maker short,” “buy,” “buy-to-cover” or “long” and reported in real time through the consolidated tape.

• Within two years the SEC is to submit a study on the state of short selling after recent rule changes.

• Within three years the GAO is to furnish a study on the criteria for determining who is an accredited investor and the eligibility to invest in private funds. (The Act also requires the SEC to review the definition of accredited investor as it applies to individuals and four years after enactment make appropriate adjustments to the net worth requirements in view of economic conditions).

• Within three years the GAO is to complete a study regarding certain aspects of the custody rules and their impact.

Additional note: Yesterday’s article on the latest Dell settlements states that neither settling defendant relinquished his right to appear and practice before the Commission. Yesterday, the Commission posted the litigation release related to the two settlements (dated last Friday) which notes that Messrs. Davis and Imhoff agreed to be prohibited from practicing before the Commission as accountants in related administrative proceedings which will be filed. Mr. Davis has a right to apply for reinstatement after five years while Mr. Imhoff will have that right after three years. An addendum was added to yesterday’s article noting this important part of the settlement after I was notified about it by the staff. Thank you to the staff for the notification.

For years, Dell Inc. shareholders, the investing public and the markets were told that the company had a superior business model. The company met street expectations quarter after quarter and year after year with such consistency that a skeptical analyst might have wondered about the results. Apparently nobody did.

Dell’s picture perfect results began to unravel in 2007 with an internal investigation and eventually disclosures of wrongful conduct and a restatement. The story took a further turn last month when the company, its founder Michael Dell and others, settled an enforcement action with the SEC. There, the Commission’s complaint focused on a scheme which took place from 2003 through 2007. It concealed the fact that large parts of the company’s revenues came, not from superior products and management, but from payments some might consider anticompetitive – Intel paid Dell not to use the products of a competitor. Whatever the propriety of these payments, investors and the market were entitled to know that a significant portion of Dell’s revenue came from them, not superior management as claimed, according to the Commission.

The company, Mr. Dell and others settled. The settlements were generally based on claimed violations of Securities Act Sections 17(a)(2)&(3), a kind of negligent fraud, and various books and records charges as discussed here. There were, of course, penalties.

On Friday, another chapter in the Dell accounting saga unfolded. Settled enforcement actions were filed against Robert W. Davis and Randall D. Imhoff. SEC v. Davis, Case No. 1:10-cv-01464 (D.D.C. Filed Aug. 2, 2010); SEC v. Imhoff, Case No. 1:10-cv-01465 (D.D.C. Filed Aug. 27, 2010). Mr. Davis, a CPA, served as Dell’s Vice President of Corporate Planning and Reporting beginning in 2001. In November 2002, he was named V.P. of Corporate Finance and Chief Accounting Officer. He held this position until February 2005, when he left the company to become CFO of Computer Associates, Inc. Mr. Imhoff, also a CPA, joined Dell in 2000 as Corporate Assistant Controller and was named Finance Director for U.S. Small and Medium Business in September 2003. From November 2005 through April 2007 when he left the company he served as Finance Director for Global I/T.

The two complaints, although not identical, essentially detail a scheme to improperly boost revenues and meet street expectations beginning as early as 2001 and continuing through at least 2005. The complaint against Mr. Davis, for example, claims that beginning in fiscal year 2002 and continuing through fiscal year 2005 the company utilized “cookie jar” reserves and other manipulations to achieve its financial objectives. During the period, Dell maintained excess accruals in multiple reserve accounts. Those excess accruals were used to offset the financial statement impact of future expenses. One reserve manipulated was known as the Strategic or “Strat Fund.” It was a subset of account 24990 called “Corporate Contingencies.” Generally, it was used to reduce operating expenses by making releases to cover unforeseen or unplanned expenses. According to the SEC, “Davis planned and issued instructions regarding Dell’s build-up and use of Corporate Contingencies.”

The other reserves manipulated included: 1) Relocation accruals; 2) Corporate restructuring reserve; 3) Several reserves in one of Dell’s overseas business units; 4) Bonus and profit-sharing accruals; and 5) an under-accrued restructuring Las Cimas reserve.

The manipulation of these reserves permitted the improper management of revenue. It also fundamentally altered key metrics and ratios. Dell, for example, highlighted for investors its OpEx ratio – a ratio of operating expenses as a percentage of revenue. The company told investors that the ratio remained flat or continued to “record low” which meant that its cost reduction initiatives and focus on controls was successful. In fact, the ratio varied greatly from period to period when computed with the correct data.

Mr. Davis settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(1) & (2), Exchange Act Section 13(b)(5) and from aiding and abetting violations of Exchange Act Sections 13(a) and 13(b)(2)(A) & (B). He also agreed to disgorge $19,080 along with prejudgment interest and pay a civil fine of $175,000. Mr. Imhoff consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 13(b)(5) and from aiding and abetting violations of Sections 13(a) and 13(b)(2)(A) &(B). He also agreed to disgorge $12,852 along with prejudgment interest and to pay a civil fine of $25,000. Neither defendant was barred from serving as an officer or director. There is no indication in the papers that either defendant will be barred from practicing before the Commission under Rule 102(e) as an accountant, although it is possible such actions will be filed later.

Reading all of the Dell actions together it is clear, according to the Commission, that shareholders and the markets were furnished with materially inaccurate financial information from as early as 2001 through 2007. Those inaccuracies were bolstered by company and management statements attributing the consistently good results to management expertise and good controls. In 2007, an internal investigation by the company found otherwise. It uncovered the accounting irregularities and wrong doing, disclosure was made and eventually there was a restatement correcting the financial statements. The Commission investigated, found years of wrong accounting, manipulated reserves and incorrect statements, but no intentional fraud.

Note to Readers: After the publication of this article the Commission Litigation Release became available. It states that both defendants consented to the entry of orders under Rule 102(e) which suspend their right to appear and practice before the Commission as an accountant. Mr. Davis can apply for reinstatement after 5 years while Mr. Imhoff can apply after three years. See Litig. Rel. 21634 (Aug. 27, 2010 but not available until Aug. 30, 2010).

The Commission adopted its controversial “proxy access” rules this week by what is becoming the standard 3-2 vote. SEC enforcement brought an insider trading case against two residents of Spain just days after the announcement of the take over bid on which it centers and obtained a partial settlement in an international financial fraud case. Option backdating cases continued to move toward resolution with the settlement of two more derivative actions.

Market reform

The Commission adopted its new “proxy access” rules by a 3-2 vote this week. Under the new rules, which take effect 60 days after publication, shareholders who own at least 3% of the total voting power of the company’s securities and have held those shares for at least three years will be eligible to nominate directors and have proposals included in the company proxy materials sent to all shareholders. Shareholders can nominate one director or a number up to 25% of the board, which ever is greater. Nominees must not violate applicable laws and regulations. Shareholders cannot use the rules if the securities are held for purposes of changing control. The rules will apply to all Exchange Act reporting companies but be phased in for small issuers. They do not apply to foreign private issuers.

SEC enforcement actions

Insider trading: SEC v. Garcia, Civil Action No. 10C 5268 (N.D. Ill. Filed Aug. 20, 2010). The case names as defendants Juan Jose Fernandez Garcia, the Head of European Equity Derivatives at Banco Santander, S.A., and Luis Martin Caro Sanchez, both of Madrid, Spain (discussed here). It centers on the unsolicited bid for Potash Corporation of Saskatchewan, Inc. by BHP Billiton Plc, announced on August 17, 2010. In the bid, BHP offered a 16% premium to market or $130 per share for the stock of Potash. Potash was advised on the bid by Banco Santander, S.A. The day after the bid the share price of Potash rose over 27%.

Shortly before the deal announcement, Mr. Garcia purchased 282 Potash call options for approximately $13,669 through Interactive Brokers. On August 17, 2010, after the take over announcement, Mr. Garcia sold his holdings for a profit of $576,033. Mr. Sanchez purchased 331 call options in Potash in mid-August at a cost of $47,499 through Interactive Brokers. Mr. Sanchez sold his position just after the announcement at a profit of $496,953.33. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is in litigation.

Financial fraud: SEC v. Escala Group, Inc., Case No. 09 CV 2646 (S.D.N.Y. March 23, 2009). The Commission settled with the founder and former chairman of Escala, Gregory Manning (here). Escala is an international company whose business centers on the collectibles market. Through a series of transactions involving collectable stamps with related parties, the Commission claims that Mr. Manning and the other defendant fraudulently boosted the revenues of Escala just prior to a merger. The related party transactions were disclosed as being at arms length. The scheme also included round trip transactions and improperly recorded expenses. Overall revenues were improperly increased by over $80 million. Mr. Manning resolved the case with the Commission by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting Escala’s violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). He also agreed to pay $669,489 in disgorgement, prejudgment interest and penalties and to the entry of an officer and director bar for ten years.

FINRA

Undisclosed conflict of interest: Zions Direct, Inc. was fined $225,000 by FINRA in connection with its failure to disclose a potential conflict of interest in auctioning certificates of deposit through its website. The potential conflict stems from the fact that Liquid Asset Management, an affiliate, participated in the auctions. From the commencement of the auctions in February 2007 through November 2008 LAM’s participation was not disclosed. Even following disclosure of its participation, the potential conflict was not disclosed. FINRA determined that customers were potentially disadvantaged in the auctions. The regulator also concluded that Zions Direct advertisements in connection with the auctions were misleading.

Private actions

Option backdating: In re Blue Coat Systems, Inc. Derivative Litig., Case No. 5:06-cv-04809 (N.D. Cal.); In re Blue Coat Systems, Inc. Derivative Litig., Case No. 1:05-cv-041436 (Sup. Ct. Cal., Santa Clara). The complaints, filed in 2007, against the directors, former directors and outside auditors Ernst & Young, alleged that the company had backdated and used spring loaded options since 1999. It was based on a report from an internal investigation. To settle the action, the company will adopt certain corporate governance provisions. Insurers and E&Y will pay about $3.9 million and certain former executives will repay about $170,000 in compensation. Plaintiffs counsel will be given $1.775 million worth of Blue Coat stock and $225,000 in cash from E&Y as attorney fees and costs.

FSA

The U.K. Financial Services Authority fined Societe Generale approximately $2.25 million (£ 1.575 million) for filing inaccurate reports on 80% of its trades over a two year period. From November 2007 through February 2010, the bank failed to report 320,000 trades and furnished inaccurate data on 531,000 transactions. Other reports had inaccurate counterparty data. The bank is the sixth institution to be fined in connection with inaccurate reports. Previously, Barclays, Getco, Instinet and Commerzbank were fined for similar irregularities. The difficulty stems from the 2007 adoption of the Markets in Financial Instruments Directive which imposed new reporting requirements on European Union financial institutions.

Investigating insider trading is difficult. Proving it is even more difficult. Frequently, the trading is “suspicious” because of its timing, magnitude, or for a variety of other reasons. Market watchers such as FINRA use this term to classify trading that merits additional investigation. It is a starting point, not a conclusion and clearly not proof of insider trading. More is needed.

Sometimes suspicious trading becomes the predicate for an enforcement action. This is the case in the Commission’s most recent insider trading case, SEC v. Garcia, Civil Action No. 10C 5268 (N.D. Ill. Filed Aug. 20, 2010). The case was filed just three days after the takeover announcement on which it centers. The defendants are Juan Jose Fernandez Garcia and Luis Martin Caro Sanchez, both of Madrid, Spain. As in many such cases, the SEC sought and obtained emergency relief, freezing the brokerage accounts of the two defendants and securing an order for expedited discovery.

The case centers on the unsolicited bid for Potash Corporation of Saskatchewan, Inc. by BHP Billiton Plc, announced on August 17, 2010. In the bid, BHP offered a 16% premium to market or $130 per share for the stock of Potash. Potash, the world’s largest fertilizer company, was advised on the bid by Banco Santander, S.A. It shares are traded on the New York and Toronto Stock Exchanges and its options are listed on the Chicago Board Options Exchange. BHP is a global natural resources company based in Australia. The day after the bid, the share price of Potash rose over 27%. The bid was ultimately rejected.

On August 12, 13, and 16 Mr. Garcia purchased 282 Potash call options for approximately $13,669 through Interactive Brokers. Virtually all of the contracts were in the “front month” August series and were due to expire on August 21, 2010. Most were out of the money when purchased by Mr. Garcia. On August 17, 2010, after the take over announcement, Mr. Garcia sold his holdings for a profit of $576,033.

From January 1 through August 12, 2010, Mr. Garcia did not trade in any Potash securities at Interactive Brokers and he engaged in what the complaint calls “minimal” options trading. At the time of the purchases, Mr. Garcia was the Head of European Equity Derivatives at Banco Santander, S.A. Mr. Sanchez purchased 331 call options in Potash on August 12 and 13, 2010, at a cost of $47,499. All of the options were due to expire on September 18, 2010, and were out of the money. They were purchased through Interactive Brokers. From January 1 through August 12, 2010, Mr. Sanchez did not own or trade any Potash shares at Interactive. The day after the take over bid was announced Mr. Sanchez sold his position in Potash for a profit of $496,953.33. He has been unsuccessful in attempts to withdraw the funds.

The complaint claims that the trading of Messrs. Garcia and Sanchez is “suspicious.” That allegation leads to the statement that “on information and belief” Messrs. Garcia and Sanchez traded on inside information. Perhaps so.

The complaint may, however, be more noteworthy for what it does not state. It does not claim that Mr. Garcia accessed or learned material non-public information through his work. It does not claim that Mr. Garcia tipped Mr. Sanchez, although it alleges that the trading patterns in Potash options are similar. It does not claim that Mr. Garcia knows or ever communicated with Mr. Sanchez. It does not allege that trading options is atypical for either defendant, other than to note that Mr. Garcia’s trading in this regard earlier in the year was minimal. It does not analyze the historical trading of either defendant beyond what occurred over the last few months in one account.

In some cases where the Commission has quickly filed insider trading charges it has been successful such as SEC v. Wong, Civil Action No. 07 Civ. 3628 (S.D.N.Y.) (here). In other instances, the defendants are demanding that the Commission prove its case such as SEC v. Condroyer, Case No. 1:09-cv-3600 (N.D. Ga.) (here). In still others the Commission has been unable to prove the claim at trial such as SEC v. Rorech, Civil Action No. 09 Civ. 4329 (S.D.N.Y.) (here).

Regardless of the results here, it is clear the proving insider trading based primarily on a set of trades in advance of a corporate event is not only difficult, but perhaps as much luck as anything else. Aggressive and efficient enforcement is important and can facilitate the program. Enforcement based on luck does not. The need for speed – even if one or both of the defendants are attempting to withdraw their trading profits – should not eclipse getting it right. It clearly is not a reason to rely on luck rather than sound investigation and evidence.

The SEC resolved part of an international accounting fraud case, settling with the former CEO of Escala Group, Inc., Gregory Manning. SEC v. Escala Group, Inc., Case No. 09 CV 2646 (S.D.N.Y. March 23, 2009). Escala is now known as Spectrum Group International.

In Escala, the Commission, with the assistance of the Special Prosecutions Office for Financial Offenses relating to Corruption, Madrid, Spain, brought an action against Connecticut based Escala, an entity that is a global network of companies in the collectibles market and that was traded on Nasdaq. The Commission also named as defendant the former CFO of the company, Larry Crawford. Escala’s parent is Afinsa Bienses Tangibles, S.A., a Spanish company engaged in commercial and trading activities.

The scheme centered on related party transactions between Escala and Afinsa which added over $80 million to Escala’s revenues as discussed here. This permitted the company to meet earnings forecasts for fiscal 2004 and the first quarter of 2005.

Revenues were improperly boosted, according to the Commission, through undisclosed related party transactions involving the sale of stamps with a friend of Mr. Manning which also gave him control of a valuable catalogue and the ability to set prices. The sales were held out as being at arms length. The defendants also falsely disclosed that Escala sold Afinsa several archives, when in fact Mr. Manning had the ability to set prices and influence appraisals. In addition, the scheme employed round trip transactions and the improper reporting of business combination expenses as a “sale” of certain antiques. As a result Escala’s share price increased from $1.47 per share on the day the company and Afinsa entered into a merger agreement at $32 per share.

The scheme came to an end in 2006 when Spanish authorities raided Afinsa’s offices. Charges were brought against certain individuals alleging that they had engaged in an unlawful pyramid scheme.

Mr. Manning resolved the case with the Commission by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting Escala’s violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). He also agreed to pay $669,489 in disgorgement, prejudgment interest and penalties and to the entry of an officer and director bar for ten years. See also Litig. Rel. 21630 (Aug. 24, 2010).

Dodd-Frank focuses on the structure of credit rating agencies, requiring revisions and imposing other requirements in an effort to resolve the conflicts of interest and other difficulties many believe were at the center of the market crisis. The article on Monday focused on the new SEC office which will deal with NRSROs and the structural issues.

One key aspect of the new requirements deals with the revolving door issue and imposes certain disclosure requirements to try and solve this problem as described in Part I. Those provisions will be supplemented by SEC rules. The Commission is required to establish rules with a look back requirement focused on when an employee of an entity subject to an NRSRO rating was employed by the agency when that person participated in determining ratings for the entity within one year.

While the Act deals with certain specific structure and operations issues of NRSROs, the SEC is required to write rules addressing others. These include:

• Influences on ratings: Rules to preclude ratings from being influenced by sales and marketing. The penalties must be registration suspension or revocation.

• Rating symbols: Rules defining the meaning of rating symbols and requiring that they be used consistently. The NRSRO is required to use distinct symbols to denote credit ratings for different types of instruments.

• Probability of default: Rules requiring that each NRSRO assess and disclose the probability that an issuer will default or otherwise not make payments in accord with the terms of the instrument.

• Qualifications: Rules regarding the qualifications, knowledge, experience and training of persons who perform ratings.

• Performance information: Rules requiring the disclosure of information which will allow an evaluation of the accuracy of ratings and foster comparability among the agencies.

• Basis of ratings: Rules requiring each NRSRO to disclose information about the underlying assumptions, procedures and methodologies employed as well as the data used on a form which will accompany each rating issued.

The Commission is authorized by the Act to suspend or revoke the registration of any NRSRO with respect to a particular class of securities if it determines that the organization lacks adequate financial or managerial resources to consistently produce ratings with integrity. In making this determination, after notice and a hearing, the Commission must consider if the rating agency failed to produce accurate ratings over a sustained period of time.

Several sections of the Act address the potential liability or litigation defenses of NRSROs. These include:

• No antifraud defense: The Exchange Act provisions which prohibit the regulation of the substance of a rating are not a defense to antifraud liability.

• Expert liability: NRSROs may now be liable under Section 11 of the Securities Act. Dodd-Frank overrides Rule 436 which exempted the organizations from being considered as part of a registration statement. Accordingly, to include a report in a registration statement, consent from the NRSRO will have to be obtained.

• Regulation FD: The Commission is required to remove the exemption for credit rating agencies under Regulation FD. The Act also requires all federal agencies to review and modify regulations to remove references or reliance on credit ratings and substitute an alternative standard of creditworthiness.

• Statements: The Act specifies that statements made by credit rating agencies are subject to liability in the same manner as those of accounting firms and securities analysts under the federal securities laws. Statements by the rating agencies are also not forward looking statements.

• State of mind: To establish liability it is sufficient to state facts with particularity which give rise to a strong inference that the agency acted knowingly or recklessly failed to conduct a reasonable investigation.

Finally, Dodd-Frank requires the preparation of studies and reports which may impact the future regulation of credit rating agencies. These include:

• Structured finance ratings: The SEC is to prepare a report to Congress within twenty-four months on the credit rating process for these products. It must include a study regarding the feasibility of establishing an independent organization to assign NRSROs to determine credit rating agencies. After the report is submitted the SEC is, as it determines to be appropriate, to establish a system for the assignment of NRSROs to determine ratings for these products.

• Independence: The SEC is required within three years to complete a report on the independence of NRSROs and how this impacts ratings.

• Standardization of ratings: The SEC is required within one year to furnish a study on the feasibility and desirability of standardizing credit rating terminology across credit rating agencies and asset classes.

• Compensation: The GAO is directed to prepare a study of alternative means for compensating NRSROs to create incentives for more accurate ratings. This study is to be completed within eighteen months.

• Professional organization. The GAO must prepare within one year a study on the feasibility of creating an independent professional organization for NRSRO rating analysts. The organization would establish standards, a code of ethics and oversee the profession.

Credit rating agencies, and in particular, nationally recognized statistical rating organizations (“NRSRO”), have been thought by many to be at the center of much of what went on with the market crisis, particularly in the area of structured products. The agencies have come under significant criticism for their methodologies, lack of procedures and conflicts of interest.

Dodd-Frank seeks to address these concerns in a series of provisions dealing with oversight and structure which will be discussed in this series. Other provisions significantly impact liability. The Act also requires the SEC to write a number of rules in this area and directs that several studies be prepared, all of which promise further legislation in this area in the future. These provisions will be discussed subsequently. Prior segments of this series have dealt with portions of the legislation concerning SEC ruling making (here), SEC Enforcement (here), executive compensation (here) and corporate governance (here).

Dodd-Frank creates the new SEC Office of Credit Ratings. This Office is charged with administering SEC rules with respect to NRSRO practices in determining ratings. The Office is also required to conduct an annual examination of each NRSRO and issue a public report. The report must summarize the essential findings of the examination, identify material deficiencies, state if previous SEC recommendations have been resolved and record any response by the examined agency. The SEC is also required to establish fines and penalties for any NRSRO violations.

A key part of the new provisions deals with the structure of the rating agencies. This begins with the board of directors and its accountability for critical functions. Each NRSRO is required to have a board of directors, at least half of whom are independent. The board is charged with overseeing the implementation of internal controls regarding policies and procedures for determining ratings, as well as compensation and promotions within the organization. It is also responsible for overseeing the management of conflicts of interest through the implementation of appropriate policies and procedures.

The organization is required under the Act to maintain a documented, effective system of internal controls for determining ratings. The Commission is charged with requiring that each NRSRO prepare an annual report regarding its controls. The report must include an attestation by the CEO that describes the responsibility of management for establishing and maintaining the system.

Each NRSRO is also required to designate a compliance officer. That officer cannot perform credit ratings or participate in marketing or sales activities. Likewise, the compensation of the officer can not be tied to the financial performance of the organization. Rather, it must be arranged to assure independence.

The compliance office is charged with preparing an annual report addressing changes in the internal compliance procedures and code of ethics of the organization. The report must also examine compliance with the securities laws and the organization’s policies and procedures. The SEC is required to review the code of ethics and the conflict of interest policy of the organization annually and when there are material changes.

The Act also addresses the “revolving door” issue between NRSROs and their clients. In this regard, Dodd-Frank requires that each NRSRO report to the SEC employment of certain senior officers associated with the rating agency in the prior five years where the agency has issued a rating for an instrument during the twelve month period prior to the employment of that person. The SEC is to make this information available to the public.

Next: Commission rules