Ponzi schemes were once thought to be difficult to detect. in the wake of the market crisis and huge frauds such as Madoff, however, these cases seem to have become a staple of SEC enforcement. Last year the Commission brought over one hundred of these cases. Frequently there were parallel criminal cases or, charges were brought shortly after the SEC initiated its action. In some instances a parallel case was brought by the CFTC. Many of these cases moved forward quickly, with consents to freeze orders and the appointment of receivers charged with marshalling the assets.

Last week the Commission obtained a preliminary injunction in a Ponzi scheme case that began with a complaint filed on January 7, 2010, as discussed here. SEC v. Elkinson, Case No. 10-CA-10015 (D. Mass.). The complaint alleged that while working from home, Richard Elkinson was able to raise about $28 million over a period of several years from 130 investors in twelve states. Mr. Elkison apparently lured investors to purchase promissory notes in a business that was suppose to be brokering contracts on behalf of a Japanese firm. That firm, investors were told, manufactured uniforms for police, prison guards and others. The products were sold to large purchasers such as local governments.

Investors were given promissory notes signed by Mr. Elkinson which typically required payment within about one year. The interest rate ranged from 9% to 13%.

The SEC however claimed that Mr. Elkinson had no relationship with a Japanese uniform manufacture and that there were no contracts. While some investors did in fact receive the promised payments, the Commission claimed that they were made with funds obtained from other investors. The scheme continued as long as a sufficient number of investors rolled over their investment since much of the money was in fact diverted to the personal use of the defendant.

The Commission’s complaint charged violations of the Securities Act registration provisions in Section 5 and of the antifraud provisions of that Act as well as the Exchange Act. In granting the SEC’s request for a preliminary injunction prohibiting violations of those sections, the court also order a freeze of Mr. Elkinson’s assets and all proceeds from others, prohibited the acceptance of additional investor funds and directed that relevant documents not be altered or destroyed. Parallel criminal charges have also been filed.

Commissioner Louis Aguilar, in remarks at SEC Speaks last Friday, called for a revamping of the Commission’s 2006 Statement on Corporate Penalties, discussed here. While Commissioner Aguilar makes a good point, any reassessment should begin with a careful undertaking in the broader context of evaluating all of the SEC’s remedies as part of a comprehensive program, not just corporate penalties. See Remarks of Commissioner Luis Aguilar, SEC Speaks, Washington, D.C., February 5, 2010.

Commissioner Aguilar focused only on corporate penalties. Penalties are changing the complexion of SEC enforcement from remedial to punitive. The Commission has had the authority to impose penalties since 1990 with the passage of the Remedies Act. Reliance on huge penalties, however, really began with the WorldCom settlement. Since then, there has been an increasing use of large corporate penalties.

Penalties are punitive and seek to assure future compliance through deterrence. The idea is that imposing a huge fine punishes the wrong doer. Others will be deterred from engaging in wrongful conduct by seeing the huge penalty. The validity of this rationale is difficult to assess at best. It does, no doubt, give SEC enforcement a harsh edge which seems more in tune with criminal enforcement. Interestingly, despite the increasing use of large penalties in recent years, respect for SEC enforcement has declined.

Prior to the Remedies Act of 1990, the SEC relied on equitable remedies. The injunction and related ancillary relief were the only remedies available. Those remedies sought to ensure future compliance, but not through a hard edge punitive approach. Rather, the Commission took a forward-looking, creative approach, crafting mechanisms which would help bring a new ethics to the marketplace. New compliance procedures, monitors and other devices were employed not to punish, but to effectively give the Commission a continuing presence inside the company in a kind of on-going monitoring program. While some may have questioned the effectiveness of this approach, there is little doubt that SEC enforcement was highly respected and effective during those years.

The Remedies Act, with the authority to impose penalties, was viewed by Congress in 1990 as a supplement to the Commission’s arsenal. Penalties were not intended as a substitute for existing remedies, but only as a supplement to be used in certain situations. The idea was to add authority to an existing, highly effective program, not replace it.

By 2006, there was an increasing reliance on corporate penalties by the Commission. Under that statement issued that year, the use of corporate penalties was largely a function of two factors: 1) whether there is a direct benefit to the corporation as a result of the violation; and 2) if the penalty will recompense or further harm the injured shareholders.

Commissioner Aguilar termed the 2006 guidelines approach “misguided” and called for it to be revamped. Since the purpose of a penalty is to punish and deter, the key question in determining whether there should be a penalty is the conduct, not the factors in the 2006 release. The current guidelines do not focus on the conduct and, accordingly, should be revamped, according to Commissioner Aguilar. The Commissioner did not outline specific proposals for revamping the guidelines.

While Commissioner Aguilar raises an important point, any revamping of SEC remedies requires a broader focus. A broader inquiry should be undertaken to determine not just the standards for corporate penalties, but the overall purpose of SEC remedies and how they are to be used. While punishment and deterrence through large penalties may be appropriate in some instances, clearly there are others where the traditional remedial approach may be more effective. Focusing on only one option such as penalties misses the broader context and runs the risk of over emphasizing one remedy at the expense of others. Accordingly, when there is a reassessment of corporate penalties it should be done in the context of analyzing all of the remedial options available to SEC Enforcement to ensure that the most effective approach is used going forward.

Financial reform efforts continued on Capital Hill this week with testimony about the so-called Volker Rule which some call “Glass Steagall lite.” SEC Chairman Mary Schapiro met with her counter parts at the FSA in London to discuss coordination on topics such as rating agencies and hedge funds.

The SEC and Bank of America are trying again to settle their dispute centered on the Bank’s acquisition of Merrill Lynch, while the NY AG brought a civil fraud action against the bank and two of its officers, also centered on the Merrill acquisition. Other SEC enforcement actions centered on disclosure questions, insider trading and an offering fraud. The U.S. Attorney’s Office in New York unsealed another insider trading case in which the defendant pleaded guilty and is cooperating in the Galleon investigation. FINRA resolved two actions regarding a failure to have adequate anti-money laundering procedures. Finally, one of the very few securities class actions to proceed to trial resulted in a jury verdict for the plaintiffs.

Reform efforts

The Volker Rule: Paul Volker, former Chairman of the Federal Reserve and current Chairman of the President’s Economic Recovery Advisory Board, testified before the Senate Banking Committee this week on the so-called “Volker Rule.” Mr. Volker’s approach is designed to preclude banks from engaging in speculative activities centered on proprietary trading. While the precise terms of the plan have not been defined, many have called it “Glass Steagall lite.”

SEC – FSA Dialogue: The SEC and FSA held the fifth meeting in their on-going strategic dialogue this week. SEC Chairman Mary Schapiro met with U.S Financial Services Authority Chairman Adair Turner and Chief Executive Hector Sants in London. The discussions focused on cooperation between the staff members of the two agencies in areas which include oversight of credit rating agencies, hedge fund advisers and the clearing of OTC derivatives.

Bank of America

The SEC and Bank of America have reached a tentative settlement of the Commission’s cases arising out of the acquisition of Merrill Lynch by the Bank. SEC v. Bank of America Corporation, Case Nos. 09 -5829 & 10-0215 (S.D.N.Y.). See also Litig. Rel. 21407 (Feb. 4, 2010). According to the SEC’s complaint, the Bank misled shareholders in the proxy materials submitted in connection with seeking approval of the acquisition by omitting a key schedule noting that billions of dollars in bonuses had been approved for Merrill employees. The court previously rejected a proposed settlement in which the Bank would have consented to a permanent injunction which prohibited future violations of Section 14(a) of the Exchange Act and would have required the payment of a $33 million fine as discussed here.

Under the terms of the new proposed settlement, Bank of America will consent to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 14(a). The firm has also agreed to pay a civil penalty of $150 million which will be distributed to shareholders through fair funds. In addition, the bank also agreed to institute for a three year period a number of corporate governance provisions. Those include: an audit of internal disclosure controls; having the CEO and CFO execute certifications as to all annual and merger proxy statements; having the Audit Committee retain special counsel with expertise in disclosure issues; using a super independence standard for compensation committee members; maintaining a super independent compensation consultant; giving shareholders a say on pay; and implementing and maintaining incentive compensation principles that will be posed on its website.

An unusual feature of the proposed settlement is a Statement of Facts prepared by the staff. The Bank acknowledged that there is an evidentiary basis for the detailed factual recitations in the statement regarding the acquisition of Merrill Lynch. The statement is based on the discovery record in the case. The SEC has also filed a second complaint, discussed here, based on claims relating to the failure of the bank to update shareholders on the deteriorating financial condition of Merrill Lynch. That action is pending.

The New York AG filed an action against Bank of America and two of its former officers, Kenneth Lewis, former Chairman and CEO, and Joseph Price, former CFO. The People of the State of New York v. Bank of America, (S.Ct. of N.Y. Filed Feb. 4, 2010). The complaint centers on the acquisition of Merrill Lynch by the bank. The factual allegations focus largely on the failure of the Bank to update shareholders about the rapidly deteriorating financial condition of the broker prior to the shareholder vote on the deal, alleged misrepresentations about the deal made to the U.S. Government to obtain financial assistance and the false proxy materials used to solicit shareholder votes for the deal. The complaint seeks injunctive relief, disgorgement, penalties and attorneys fees.

SEC enforcement actions

Disclosure: SEC v. State Street Bank and Trust Co., Case No. 1:10-CV-10172 (D. Mass. Filed Feb. 4, 2010); In the Matter of State Street Bank and Trust Co. , Adm. Proc. File No. 3-13776 (Filed Feb. 4, 2010) are actions against the Bank relating to its sale of shares in the Limited Duration Bond Fund. According to the SEC, State Street sold shares in this fund as an “enhanced cash” investment strategy that was an alternative to a money market fund for some investors. In fact, the fund was invested almost entirely in sub-prime residential mortgages.

The Bank also sent investors a series of misleading communications about the Fund as the market unraveled. To resolve the case, the Bank consented to the entry of a judgment in the court action which orders it to pay a civil penalty of $50 million, disgorgement of about $7.3 million and about $1 million in prejudgment interest, all of which will be paid into a fair fund along. In addition State Street agreed to pay an additional $225 million to compensate investors. See also Litig. Rel 21408 (Feb. 4, 2010). Previously, the bank paid $340 million to some harmed investors in private actions. State Street also agreed to retain an Independent Compliance Consultant to conduct a comprehensive review of its disclosure and compliance procedures. In the administrative proceeding, the Bank agreed to an order requiring it to cease and desist from future violations of Securities Act Sections 17(a)(2) & (3).

Insider trading: SEC v. Levinberg, Case No. 10-CV-777 (S.D.N.Y. Filed Feb. 2, 2010) centers on the acquisition of Scopus Video Networks, Ltd. by Harmonic Inc. in December 2008. For several months prior to the acquisition, Scopus attempted to interest Gilat Satellite Networks in acquiring it. In an initial meeting with the defendant, an officer of Gilat, Scopus furnished confidential information about the company as a take over target. Those discussions failed. However, defendant purchased shares of Scopus prior to the take over announcement. Those shares were sold after the announcement at a profit of $187,996.48. To resolve this action, Mr. Levinberg consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions of the Exchange Act. He also agreed to disgorge his trading profits, pay prejudgment interest and a penalty equal to those profits. See also Litig. Rel. 21405 (Feb. 3, 2010).

Insider trading: SEC v. Macdonald, Case No. 3:10cv151 (D. Conn. Filed Feb 2, 2010) is a pillow talk case in which defendant Bruce Macdonald is alleged to have misappropriated inside information from his wife, traded for his account and that of a friend and tipped others as discussed here. Mr. Macdonald’s wife is the corporate secretary and vice president of human resources of Memry Corporation which had put itself up for sale. Throughout a process which led to the acquisition of the company in 2008, she was involved at each key step. As the process unfolded, Mrs. Macdonald updated her husband.

Without informing his wife, Mr. Macdonald purchased shares of the company in his business account and in the account of a long time friend for whom he regularly traded, Bruce Bohlander, a relief defendant. He also tipped three friends, including Defendant Robert Maresca. Mr. Maresca subsequently purchased 9,000 shares of stock. As a result of the trading, Mr. Macdonald had ill-gotten gains of $890 in his account and $25,508 in Mr. Bohlander’s account. Mr. Maresca had gains of $12,335, while the two unidentified traders made $7,307.50.

To resolve the case Messrs. Macdonald and Maresca consented to the entry of permanent injunctions prohibiting future violations of the antifraud provisions of the Exchange Act. Each man also agreed to the entry of an order requiring him to disgorge the trading profits along with prejudgment interest and to pay a penalty equal to the trading profits. Mr. Bohlander consented to the entry of a final judgment requiring him to disgorge the trading profits and pay judgment interest. See also Litig. Rel. 21404 (Feb. 2, 2010).

Aiding and abetting: SEC v. Cohmad Securities Corporation, Case No. 1:09-cv-05680 (S.D.N.Y. Filed June 22, 2009) is a complaint against broker dealer Cohmad Securities and its chairman Maurice Cohn, chief operating officer Marcia Cohn and registered representative Robert Jaffee. It alleges that the defendants aided and abetted Bernard Madoff’s Ponzi scheme by raising more than $1 billion from investors. This week, the court dismissed the complaint with leave to replead. The court concluded that the complaint failed to adequately plead facts demonstrating that the defendants would have been on notice of the Madoff fraud.

Offering fraud: SEC v. Winning Kids, Inc., Case NO. 10-CV-80186 (S.D. Fla. Filed Jan. 29, 2010) is an action against the company, its founder and CEO Christian Hainsworth and three former sales agents. The complaint claims that the defendants raised about $2 million from investors, supposedly for the development and marketing of books for children. According to the complaint, investors were sold unregistered securities and falsely told that the company was established and expanding nationwide. They were also provided with baseless financial projects depicting significant growth. In fact, the company had almost no revenue from the sale of books or any other product. The company and defendant Hainsworth have consented to the entry of a final judgment that enjoins them from future violations of the registration and antifraud provisions. It also orders them to pay disgorgement, prejudgment interest and civil penalties in amounts to be determined by the court. See also Litig. Rel. 21400 (Feb. 2, 2010).

Criminal cases

Insider trading: U.S. v. Slaine, Case No. 1:10-cv-00754 (S.D.N.Y. Unsealed Feb. 2, 2010) and SEC v. Slaine, Civil Action No. 10 CV 754 (S.D.N.Y. Filed Feb. 10, 2010). Defendant David Slaine was charged with, and pleaded guilty to, participating in an insider trading scheme based on material nonpublic information from former UBS analyst Mitchel Guttenberg, discussed here. Mr. Slaine pleaded guilty to conspiracy and securities fraud charges in December 2009, but the indictment remained sealed this week. Mr. Slaine is alleged to have received information about UBS investment recommendations prior to their release to the public indirectly from Mr. Guttenberg between 2001 and 2006. The information came through Erik Franklin, an analyst for Chelsey Capital. Mr. Slaine, in turn, traded for his employer’s account, Chelsey Capital, and his personal account.

Overall, Mr. Slaine made over $3 million in profits for Chelsey as a result of the information he obtained from Mr. Guttenberg through Erik Franklin. In his personal account during 2002, he made over 20 trades yielding more than $500,000 in profits from the UBS information. In the criminal case, a date for sentencing has not been set. The SEC case has not been resolved. Previously the SEC settled insider trading charges with Chelsey Capital and Mr. Franklin in connection with the resolution of the Guttenberg case as discussed here. See also Litig. Rel. 21403 (Feb. 2, 2010).

Mr. Slaine also worked at Galleon at one time (discussed here). Reportedly he is assisting prosecutors in that investigation.

FINRA

Two firms were fined for failing to have adequate anti-money laundering programs. Penson Financial Services, a Dallas based securities clearing firm, failed from October 1, 2003 through May 31, 2009 to adequately establish and implement its anti-money laundering program. In fact, even after the firm installed a sophisticated automated system in December 2007, it failed to conduct timely inquiries of suspicious activity. The firm consented to pay a fine of $450,000.

Pinnacle Capital Markets, which operates an online business providing primarily foreign customers with direct access to the U.S. securities markets, was fined $300,000 for similar violations.

Circuit courts

In The New York City Employees Retirement System v. Jobs, Case No. 5:06-CV-05208 (9th Cir. Decided Jan. 28, 2009), the court held that dilution alone is insufficient to establish loss causation as discussed here. The class action complaint against Apple, Inc. and fourteen of its directors and officers, alleged violations of Exchange Act Sections 14(a) and 20(a) for a misleading 2005 proxy solicitation. Based on option backdating claims, plaintiffs claimed that from 1996 through 2005 Apple shareholders unwittingly approved the issuance of 205 million shares based on a series of false statements. This resulted in a 20% dilution. The complaint sought rescission of the votes, compensatory damages for the share dilution, an accounting and attorney’s fees and costs.

The district court dismissed the Section 14(a) claims without leave to amend. The Ninth Circuit affirmed the dismissal, but remanded to permit plaintiffs to amend. To establish a claim under Section 14(a) the court held, a securities law plaintiff must plead loss causation. Here, the only claim is that stock ownership was diluted by 20%. Economic loss does not necessarily accompany dilution however, according to the court. Accordingly, a claim of dilution, standing alone, is not sufficient to plead loss causation.

Private actions

In Re Vivendi Universal SA Sec. Litig., Case No. 02-cv-5571 (S.D.N.Y.) is one of the few securities class actions to be tried to verdict before a jury. In this case, the jury returned a verdict against the company, concluding that it had made 57 false statements which improperly inflated its share price. The complaint claimed that, from 1996 through 2002, the company went on a multi-billion dollar acquisition spree, transforming itself from a French water company into the world’s largest music company. The misstatements were made over a two year period beginning in 2000 to mask the true financial condition of the company. The amount of damages has not been determined.

Insider trading cases large and small continue to be a key focus for SEC Enforcement. Yesterday, the Commission filed two settled insider trading case. One is a pillow talk case where apparently the husband misappropriated the inside information from the wife. The second presents a question of duty, since inside information was given to the trader and his company without an explicit confidentiality agreement. SEC v. Macdonald, Case No. 3:10cv151 (D. Conn. Filed Feb 2, 2010); SEC v. Levinberg, Case No. 10-CV-777 (S.D.N.Y. Filed Feb. 2, 2010).

Macdonald is a pillow talk case in which defendant Bruce Macdonald is alleged to have misappropriated inside information from his wife, traded for his account and that of a friend and tipped others. Specifically, the Commission’s complaint alleges that the board of directors of Memry Corporation began taking steps to sell the company in 2006. By September 2007, the company had selected an investment bank and shortly thereafter began soliciting bids. On June 24, 2008 the company announced that it was being acquired. The stock price rose 64% from $0.94 per share to $1.45.

Throughout the acquisition process, Mr. Macdonald’s wife, the corporate secretary and vice president of human resources, was involved at each key stage of the process which led to the acquisition announcement. As the process unfolded, Mrs. Macdonald updated her husband. Those updates included a discussion of a black out period imposed by the company because of the negotiations. Although the complaint does not specify that Mrs. Macdonald directed her husband to keep the information confidential, it does specify that, based on their marital relationship, he owed her a duty of trust and confidence regarding the information.

Nevertheless, without informing his wife, Mr. Macdonald purchased shares of Memry in his business account and in the account of a long time friend for whom he regularly traded, Bruce Bohlander, a relief defendant. The purchases began in July 2007 with the acquisition of 1,000 shares for his account. Subsequently, Mr. Macdonald made two purchases 24,000 shares in Mr. Bohlander’s account. One purchase was at the end of July 2007, while the second was in April 2008. In an apparent attempt to assuage any materiality issues, the complaint ties the purchases to a specific chronology of the company moving forward toward an acquisition.

In early 2008, Mr. Macdonald also tipped three friends, including Defendant Robert Maresca. Mr. Maresca subsequently purchased 9,000 shares of Memry stock. The other two friends, who are not named in the complaint, acquired a total of 8,250 shares. As a result of the trading, Mr. Macdonald had ill-gotten gains of $890 in his account and $25,508 in Mr. Bohlander’s account. Mr. Maresca had gains of $12,335 while the two unidentified traders made $7,307.50.

To resolve the case, Messrs. Macdonald and Maresca consented to the entry of permanent injunctions prohibiting future violations of the antifraud provisions of the Exchange Act. Each man also agreed to the entry of an order requiring him to disgorge the trading profits, along with prejudgment interest and to pay a penalty equal to the trading profits. Mr. Bohlander consented to the entry of a final judgment requiring him to disgorge the trading profits and pay judgment interest. See also Litig. Rel. 21404 (Feb. 2, 2010).

Levinberg involves a question of duty. The complaint is based on the acquisition of Scopus Video Networks, Ltd, an Israel company with a U.S. subsidiary, whose shares were traded on NASDAQ, by Harmonic Inc. at a substantial premium. The deal went forward under a merger agreement entered into on December 22, 2008 and announced the next day.

In September 2008, Scopus had approached Gilat Satellite Networks, Ltd about being acquired. Defendant Joshua Levinberg is an Executive Vice President of Corporate Development and Business Strategy of Gilat and a resident I Israel. An officer of Scopus made the initial approach to the defendant in an attempted to persuade Gilat to acquire the company. To try to induce a deal, the Scopus officer furnished the defendant with material nonpublic information about the company and its status as a takeover target. There is no allegation that Gilat or defendant agreed to keep the material confidential, although it was labeled as proprietary and a legend stated that it could not be disclosed or reprinted without the permission of Scopus.

The initial approach was not successful. Scopus continued during the fall of 2008, however, to pursue a deal. Those efforts continued through December 2008.

Beginning on October 31, 2008 and continuing through December 17, 2008, defendant purchased 102,172 shares of Scopus at an average cost of $3.56. The purchases were made through an account carried by a brokerage firm in Manhattan for its wholly owned Israeli subsidiary. At the time, Gilat had an insider trading policy.

Following the announcement of the acquisition of Scopus, the share price increased by 41%. Mr. Levinberg made a profit, according to the SEC, of $187,996.48.

To resolve this action Mr. Levinberg consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions of the Exchange Act. He also agreed to disgorge his trading profits, pay prejudgment interest and a penalty equal to those profits. See also Litig. Rel. 21405 (Feb. 3, 2010).

DOJ statistics for last year show that the number of prosecutions for financial crimes has dropped over the past six years, including the number of securities fraud charges. But, Preet Bharara, the U.S. Attorney for Manhattan, says that his office is focusing on white collar crime and that it has a number of cases in the pipeline. Nobody would doubt the focus of the office after the filing of the blockbuster and seemingly ever expanding Galleon insider trading cases. Taking its cue from Mr. Bharara, the SEC has also continued to expand its Galleon-related cases as discussed here.

The pipeline at the New York U.S. Attorney’s Office seems to be longer than anyone realized, however. Before Galleon, perhaps the most trumpeted insider trading cases since the 1980s were the criminal and civil actions revolving around former UBS analyst Mitchel S. Guttenberg, discussed here. Those cases appeared to have been resolved with guilty pleas and convictions in the criminal cases and consent decrees in the civil enforcement actions. It is now clear however that the investigations are continuing. Yesterday, Mr. Bharara’s office unsealed a two-count criminal information stemming from the Guttenberg cases which named David Slaine, a former employee of hedge fund Chelsey Capital as a defendant. U.S. v. Slaine, (S.D.N.Y. Unsealed Feb. 2, 2010). The SEC filed a parallel action. SEC v. Slaine, Civil Action No. 10 CV 754 (S.D.N.Y. Filed Feb. 10, 2010).

Mr. Slaine was charged with, and pleaded guilty to, participating in an insider trading scheme based on material nonpublic information from Mr. Guttenberg. Mr. Slaine pleaded guilty to conspiracy and securities fraud charges in December 2009, but the indictment remained sealed until yesterday.

According to the court papers filed by the Government and the SEC, Mr. Slaine received information about UBS investment recommendations prior to their release to the public indirectly from Mr. Guttenberg. Specifically, between 2001 and 2006 Mr. Guttenberg provided Erik Franklin, a portfolio manager for Q Capital Investment Partners, Lyford Cay Capital and an analyst for Chelsey Capital, with prerelease information about UBS investment recommendations. Mr. Franklin in turn passed the information on to Mr. Slaine who traded both for his employer and in his personal account after receiving the information.

In some instances, the information was about a downgrade recommendation. For example, on May 22, 2002 Mr. Slaine sold short 15,000 shares of Principal Financial in his personal account. The next day UBS announced it downgrade recommendation. In other instances, the information was about an upgrade. On August 14, 2002, for example, Mr. Slaine purchased 15,600 shares of Cell Therapeutics in his personal account. The next day UBS announced that it was changing its recommendation on the stock from “buy” to “strong buy.” Overall Mr. Slaine made over $3 million in profits for Chelsey as a result of the information he obtained from Mr. Guttenberg through Erik Franklin. In his personal account during 2002 he made over 20 trades yielding more than $500,000 in profits from the UBS information.

In the criminal case a date for sentencing has not been set. The SEC case has not been resolved. Previously, the SEC settled insider trading charges with Chelsey Capital and Mr. Franklin in connection with the resolution of the Guttenberg case as discussed here. See also Litig. Rel. 21403 (Feb. 2, 2010).

The SEC continues to expand the Galleon insider trading case, while the U.S. Attorney’s office rolls up more guilty pleas. SEC v. Galleon Management, LP, Civil Action No. 09-CV-8811 (S.D.N.Y.). In January, Anil Kumar pled guilty to one count of securities fraud and one count of conspiracy to commit securities fraud as discussed here. Mr. Kumar, a friend of Galleon founder Raj Rajaratnam, is a former senior partner and director of McKinsey, a global business consulting firm. He is also one of the claimed sources of inside information identified by the U.S. Attorney’s Office and the SEC from the beginning of the cases.

A Second Amended Complaint filed by the SEC on Friday provides new insight into the claimed relationship between Mr. Kumar and Galleon’s founder. See Litig. Rel. 21397 (Jan. 29, 2010). According to the SEC’s new complaint, in 2003 Mr. Rajaratnam agreed to pay Mr., Kumar $500,000 per year in return for inside information obtained from clients of McKinsey. Pursuant to this arrangement, Mr. Kumar was paid between $1.75 to $2 million by Mr. Rajaratnam through 2007, according to the complaint. The payments were channeled through a third party overseas. Eventually those payments were brought back to this country by Mr. Kumar and invested in Galleon under the name of a third party. While at Galleon, the funds grew to about $2.6 million.

In return for the payments, Mr. Kumar furnished Mr. Rajaratnam with inside information. For example, in 2004 Mr. Kumar provided information about AMD as described in earlier SEC and USAO filings. In 2006, Mr. Kumar again furnished Mr. Rajaratnam with inside information. In that instance, the information concerned the potential acquisition of ATI by AMD. Galleon purchased shares in ATI. As the deal negotiations progressed, Mr. Rajaratnam was furnished with updates. When this deal was announced in July 2006 Galleon made a profit of over $19 million.

The arrangement apparently ended in October 2007 when Mr. Rajaratnam told Mr. Kumar that he should no longer keep his investment at Galleon. Mr. Rajaratnam indicated that he was under increased scrutiny.

Just days prior to the filing of the SEC’s Second Amended Complaint, seven more individuals were indicted as part of the on-going Galleon insider trading investigation. The individuals named in that indictment, discussed here, were among fourteen previously identified. As this investigation goes forward, there seems to be little doubt that the USAO will bring more indictments and obtain more guilty pleas. At the same time, the SEC can be expected to continue to expand its case.

Seminar

Trends in SEC Enforcement 2010, a web cast by Thomas O. Gorman, Tuesday, February 2, 2010 from 12:00 p.m. to 1:00 p.m. Sponsored by West Legal Ed and Celesq Legal Ed. http://www.celesq.com/programs/view/trends-in-sec-enforcement-2010

In Dura Pharmaceuticals, Inc. Broudo, 544 U.S. 336 (2005), the Supreme Court reversed a decision upholding the adequacy of a securities class action complaint. The Court held that the complaint did not adequately plead loss causation, that is, the economic link between the claimed fraud and injury. The decision resolved a conflict among the circuits. In Dura, however, the Court did not actually specify what constitutes loss causation. Rather, it stated what is not loss causation – only pleading price inflation. Since the decision in Dura, the courts have struggled to define what does and does not constitute loss causation.

In New York City Employees Retirement System v. Jobs, Case No. 5:06-CV-05208 (9th Cir. Decided Jan. 28, 2009), the circuit court eliminated another claimed theory of loss causation – dilution. The class action complaint against Apple, Inc. and fourteen of its directors and officers, alleged violations of Exchange Act Sections 14(a) and 20(a) for a misleading 2005 proxy solicitation. The complaint, grounded in option backdating claims, alleges that from 1996 through 2005 Apple shareholders unwittingly approved the issuance of 205 million shares based on a series of false statements. This resulted in a 20% dilution. The complaint sought rescission of the votes, compensatory damages for the share dilution, an accounting, and attorney’s fees and costs.

The district court dismissed the Section 14(a) claims without leave to amend, although the court did permit amendment of other derivative claims. In dismissing the Section 14(a) claims the court held, in part, that plaintiffs had failed to adequately plead loss causation.

The Ninth Circuit affirmed as to the pleading of loss causation, but remanded to permit plaintiffs to amend. To establish a claim under Section 14(a) the court held, a securities law plaintiff must plead loss causation. Under SOX, a plaintiff must show that the defendant “caused the loss for which the plaintiff seeks to recover damages.” Dura requires a plaintiff to prove economic loss. Accordingly, in the complaint, a securities law plaintiff must give notice of “what the relevant economic loss might be or of what the causal connection might be between that loss and the misrepresentation.”

Plaintiffs in this case tried to side step Dura, arguing that their claim is really grounded in rescission. SOX however does not differentiate between legal and equitable remedies according to the court. Therefore, plaintiffs must plead economic loss.

Furthermore, while it is correct that Dura does not specify the manner in which that loss must be established, as plaintiffs contend, the complaint must provide notice of that loss the court stressed. Here, the only claim is that ownership was diluted by 20%. As the district court concluded, economic loss does not necessarily accompany dilution. Accordingly, a claim of dilution, standing alone, is not sufficient to plead loss causation under SOX and Dura.

Reform efforts continued this week with the introduction of a bill in the House of Representatives focused on the risk posed by large companies. The Galleon cases continued to move forward with the return of indictments against seven more individuals. SEC enforcement focused on insider trading and short selling actions. FCPA enforcement received a set back in a major case, however, from a ruling in the Bahamas.

In the circuit courts, the PSLRA scienter pleading requirements continued to have a significant impact. In private actions, another derivative suit based on option backdating claims settled.

Reform efforts

H.R. 4516, titled The Financial Services Industry Stability Act of 2010, was introduced in the House of Representatives on January 26, 2010. In general, the Act charges the head of each Federal department or agency, in consultation with the Chairman of the Federal Reserve, to “take such steps as may be necessary to ensure that no financial company is able to pose a systemic risk to the health of the United States economy by becoming to large to fail.” A report on this matter is to be filed annually with Congress.

SEC enforcement actions

Offering fraud: SEC v. Tsukuda-America Inc., Case No. 3:10-CV-00136-M (N.D. Tex. Filed Jan. 28, 2010) is an action against the company and its principal John Petros alleging fraud in connection with a $600,000 offering. According to the complaint, the registration statement contained: a forged audit report; a false identification of the transfer agent; a bogus legal opinion and geologist report; and sham consents from an attorney and geologist who did not exist. The complaint alleges violations of Securities Act Section 17(a). A related administrative proceeding based on Securities Act Section 8(d) was previously filed. In the Matter of Registration Statement of Tsukuda-America Inc., Adm. Proc. File No. 3-13761 (Jan. 26, 2010).

Short selling: In the Matter of Palmyra Capital Advisors LLC, Adm. Proc. File No. 3-13783 (Jan. 26, 2010). Palmyra Capital Advisors is an LA-based hedge fund manager that advises three limited partnerships. The three funds, according to the SEC, sold short 50,000 shares of Capital One in mid-September 2008. About one week later, Capital One announced the pricing for a secondary offering at about $6 per share under the price at which the three funds had sold short. The three funds subsequently received 50,000 shares in the offering yielding a profit of $225,000 in violation of Regulation M as discussed here.

To settle the action, Palmyra consented to the entry of a censure. The firm also agreed to pay disgorgement of $225,000, prejudgment interest and a civil penalty of $105,000. In settling this matter, the SEC considered the prompt remedial actions of the Respondent and its cooperation.

Short selling: In the Matter of AGB Partners LLC, Adm. Proc. File No. 3-13764 (Jan. 26, 2010). Investment adviser AGB Partners advised two private funds. One account belonged to AGB Partners. A second belonged to Del Rey Management. Respondents violated Regulation M in two transactions, according to the Order. In one deal AGB Partners sold short 173,632 shares of Boots and Coots in April 2007. Shortly thereafter, 35,000 shares acquired in a secondary offering by Del Rey were used to cover part of the short position. This transaction yielded a profit of $16,450.

In a second transaction, BCG priced its secondary offering at $8 per share in June 2008. Del Rey purchased 200,000 shares in the offering. The prior month AGB Partners sold short 16,200 shares of BGC Partners at an average price of $8.45 per share. By participating in the secondary offering, a virtually risk free profit of $14,704 was made. Both transactions violated Regulation M, according to the Order. To settle the action, Respondents consented to the entry of a censure. In addition, they agreed to disgorge trading profits of about $38,000 along with prejudgment interest and to pay a civil penalty of $20,000.

Insider trading: SEC v. Nothern, Civil Act No. 05-CV-10983 (D. Mass. Filed May 12, 2005). Steven Nothern, a former executive at Massachusetts Financial Services, is the last defendant to resolve a long running insider trading case as discussed here. According to the SEC, Mr. Nothern was provided with material non-public information from an agent who attended the Treasury Department’s quarterly refunding press conferences. At an October 31, 2003 conference, Treasury announced that it would suspend issuance of the 30 year bond later that morning. The news was embargoed until 10:00 a.m. Mr. Nothern obtained this information from the agent who attended the conference. Mr. Nothern and the two traders to whom he provided the inside information traded for three MFS funds. When the news was made public the price of the bonds soared. The three funds made profits of $3.1 million.

To settle the action, Mr. Nothern consented to the entry of a permanent injunction prohibiting future violations of Section 10(b) of the Exchange Act and Rule 10b-5. Mr. Nothern also agreed to pay a civil penalty of $460,000. The settlement followed a jury trial that concluded in June 2009 in favor of the Commission. The agent and another market professional who traded after being tipped both pleaded guilty to criminal charges. Mr. Nothern was not charged criminally.

Insider trading: SEC v. Fogel, Case No. 1:10-CV-10097 (D. Mass. Jan. 22, 2010). This is a settled insider trading case against Avi Fogel, the former Vice President of strategic initiatives at EMC Corporation as discussed here. It centers on the acquisition of Document Sciences Corporation, or DOCX, a global provider of customer communications management solutions by EMC. The public announcement of the deal was made prior to the opening of the markets on December 27, 2007. Although Mr. Fogel was part of the team which worked on the acquisition, shortly prior to the public announcement, he purchased 30,000 shares of DOCX stock in two transactions. Following the announcement, the share prices increased from just over $8 to over $14 for a 76% increase.

To settle the case, Mr. Fogel consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions. He also agreed to disgorge $191,393, pay prejudgment interest of $14,639.62 and to pay a penalty of $191,363. See also Litig. Rel. 21392 (Jan. 22 2010).

FCPA

U.S. v. Kozeny, Case No. 1:05-cr-00518 (S.D.N.Y.) is an FCPA case in which Frederic Bourke, co-founder of handbag maker Dooney & Bourke, was convicted last year and sentenced to a year and a day in prison as discussed here. The case is based on a scheme to bribe government officials in Azerbaijan to ensure that they would privatize the State Oil Company in a rigged auction. This would permit a consortium in which he was a member to profit. Defendant Viktor Kozeny has been at large. This week, a court in the Bahamas rejected a U.S. request to extradite Mr. Kozeny who has resided in the Bahamas since 1995. The ruling was based on the requirement that for extradition the charges must be an offense under the laws of both countries.

Criminal cases

Galleon insider trading cases: This week seven more individuals were indicted in this on-going insider trading investigation discussed here. The seven defendants are among the fourteen charged earlier. They are: Zvi Goffer, formerly a Galleon employee and trader at Schottenfeld Group; Arthur Cutillo of Ropes & Gray; Jason Goldfarb, an attorney; Craig Drimal, a trader who worked at Galleon; Emanuel Goffer; Michael Kimelman of Incremental Capital; and David Plate of the same firm. U.S. v. Goffer, Case No. 1:10-cr-0056 (S.D.N.Y. Filed Jan. 21, 2010).

Circuit courts

Edward J. Goodman Life Income Trust v. Jabil Circuit, Inc., No. 09-10954 (11th Cir Decided Jan. 19, 2010) affirmed the dismissal of a securities class action for failure to plead scienter as discussed here. Plaintiffs alleged in their complaint against the technology company and certain of its officers that the defendants had fraudulently backdated stock option grants, causing earnings to be overstated by $54.3 million. This caused a restatement. A company inquiry concluded that there was no evidence of high level employees issuing themselves backdated options. The applicable accounting principles however had been misapplied.

In affirming dismissal, the circuit court concluded that scienter had not been adequately pleaded under Tellabs, Inc. v. Makor Issues & Rights, 551 U.S. 308 (2007) (discussed here). The standard for scienter in the eleventh circuit is “severe recklessness.” Although the plaintiffs did not plead particularized facts that any individual officer knew about the option practices, they claimed that the restatement is a virtual admission of liability, particularly in view of its magnitude. Plaintiff sought to bolster this claim by arguing that a significant percentage net income was misstated each year. The court rejected these claims. Backdating options is not, in and of itself, improper the court noted. The critical question is whether the accounting is done correctly. Here, there are no facts to demonstrate that any individual defendant knew the accounting standards had been violated. Likewise, plaintiffs’ claims regarding the percentage of net income are unavailing because net income is a variable metric. Finally, plaintiff’s contention that the amount of the misstatement was so large that it must have been a red flag does not demonstrate a strong inference of scienter.

Private actions

In re Black Box Corporation Derivative Litig., Case No. 2:06-cv-01531 (W.D. Pa. Filed Nov. 16, 2006) is a shareholders derivative suit based on option backdating claims. The complaint notes that in the 2007 Black Box restated 12 years of quarterly and annual financial reports because it had mispriced $71 million of options. The parties have agreed to settle the case with a payment of $6 million plus $1.6 million in attorney fees. Previously, the former CFO of the company settled an enforcement action based on option backdating claims with the SEC.

Foreign

A new report by NERA on Trends in Canadian Securities Class Actions notes that for 2009 the number of filings remained above historical averages. In 2009, the number of suits filed declined to eight from ten the prior year but remained above the historical average. This type of suit is just developing in Canada. Settlement values in 2009 declined compared to 2008.

Seminar

Trends in SEC Enforcement 2010, a web cast by Thomas O. Gorman, Tuesday, February 2, 2010 from 12:00 p.m. to 1:00 p.m. Sponsored by West Legal Ed and Celesq Legal Ed. http://www.celesq.com/programs/view/trends-in-sec-enforcement-2010

Since at least the beginning of the market crisis when it took emergency actions, short selling has been a key focus for the Commission. Last year, it passed new regulations on short selling. The agency also filed its first naked short selling case as well as others targeting the practice in certain instances. See, e.g., In the Matter of TJM Proprietary Trading, LLC, Adm. File No. 3-13569 (Aug. 5, 2009) (discussed here) and In the Matter of Hazan Capital Management, LLC, Adm. File No. 3-1570 (Filed Aug. 5, 2009), also discussed here. See also In the Matter of Rhino Trading, LLC, Adm. Proc. File No. 3-013677 (Filed Nov. 4, 2009) (Reg. SHO), discussed here; In the Matter of First New York Securities LLC, Adm. Proc. File No. 3-13656 (Filed Oct. 20, 2009) (same), discussed here.

The SEC continued this trend this week, filing two more short selling cases based on Regulation M as it existed prior to the 2007 amendments and after. In the Matter of Palmyra Capital Advisors LLC, Adm. Proc. File No. 3-13783 (Jan. 26, 2010); In the Matter of AGB Partners LLC, Adm. Proc. File No. 3-13764 (Jan. 26, 2010).

The first action is against Palmyra Capital Advisors, an LA-based hedge fund manager that advises three limited partnerships. According to the Order, the three funds advised by Palmyra sold short 50,000 shares of Capital One in mid-September 2008. About one week later, Capital One announced the pricing for a secondary offering at about $6 per share under the price at which the three funds had sold short. The three funds subsequently received 50,000 shares in the offering yielding a profit of $225,000.

This transaction violated Regulation M, according to the Commission. That Regulation prohibits selling short a security that is the subject of an offering and then purchasing the securities from the underwriter or an offering participant within specified time limits. The Commission implemented this restriction to prohibit what it called manipulative short selling or “shorting into the deal.” Typically, a secondary offering is priced below the market, meaning that the trader who shorts the stock shortly prior to the deal engages in a transaction with virtually no risk and has an unfair advantage. It can also result in reduced proceedings from the offering for the issuer. Here, the Commission found that Palmyra violated the Rule.

To settle the action, Palmyra consented to the entry of a censure. The firm also agreed to pay disgorgement of $225,000, prejudgment interest and a civil penalty of $105,000. In settling this matter, the SEC considered the prompt remedial actions of the Respondent and its cooperation.

The AGB Partners action is similar. There, AGB Partners, an investment adviser, advised two private funds. One account was AGB Partners’ own account which traded for its principals. A second belonged to Del Rey Management, which was funded by outside investors.

Respondents violated Regulation M in two transactions, according to the Order. In one regarding the shares of Boots and Coots, AGB Partners sold short 173,632 shares in mid- April 2007. Shortly thereafter, 35,000 shares acquired in a secondary offering by Del Rey were used to cover part of the short position. This transaction yielded a profit of $16,450.

The second set of transactions involved a follow-on offering of the shares of BGC Partners Inc. In June 2008 BCG priced its offering at $8 per share. Del Rey purchased 200,000 shares in the offering for its account. The prior month, AGB Partners sold short 16,200 shares of BGC Partners at an average price of $8.45 per share. By participating in the secondary offering, a virtually risk free profit of $14,704 was made.

Both transactions violated Regulation M, according to the order. The first violated the pre-amendment version of the Regulation, while the second is contrary to the post-amendment version. In addition, although the transaction regarding Boots and Coots involved two different accounts, it was still prohibited. Regulation M does contain an exception for transactions involving separate accounts. Here, however, since the accounts were under common control, the exception does not apply.

To settle the action, Respondents consented to the entry of a censure. In addition, they agreed to disgorge their trading profits of about $38,000 along with prejudgment interest and to pay a civil penalty of $20,000.

The line between criminal and civil securities fraud is often difficult to detect. The federal securities laws give the SEC the right to bring civil enforcement actions based on violations of the antifraud provisions. The Department of Justice has the right to file criminal charges based on violations of those same sections if the conduct is also “willful.” The line between a “scienter” based violation of the antifraud provisions and a “willful” and “scienter” based violation of those sections is often difficult to detect.

The issue is highlighted by an SEC case that concluded this week, but began in 2003. The SEC settled an insider trading case with Steven Nothern, formerly a senior vice president of Massachusetts Financial Services Company in Boston. SEC v. Nothern, Civil Act No. 05-10983 (D. Mass. Filed May 12, 2005). Under the terms of the settlement, Mr. Nothern consented to the entry of a permanent injunction prohibiting future violations of Section 10(b) of the Exchange Act and Rule 10b-5. Mr. Nothern also agreed to pay a civil penalty of $460,000. The settlement followed a jury trial that concluded in June 2009 in favor of the Commission.

The settlement with Mr. Nothern stems from an action initially filed by the Commission in 2003. SEC v. Davis, Case No. 03-CV6672 (S.D.N.Y. Filed Sept. 4, 2003). That case was brought against: Peter Davis, Jr., who provided advice to broker dealers, financial analysts and investors regarding Washington political and financial events; John Youngdahl, formerly a Vice President and Senior Economist at Goldman Sachs’ Global Economic Group, who sat on the Treasury Desk where he advised traders on economic and political developments; and Mr. Nothern, tasked by MFS with the management of seven fixed income mutual funds, including one that invested in Treasury securities.

According to the 2003 SEC complaint, Mr. Davis attended the Treasury Department’s quarterly refunding press conferences. The participants at those conferences were provided with market sensitive information which was subject to a press embargo. At an October 31, 2003 refunding press conference, Treasury announced that it would suspend issuance of the 30 year bond later that morning. The news was embargoed until 10:00 a.m. Mr. Davis had been attending these quarterly conferences since 1994. He had an explicit agreement with Treasury that he would comply with its regulations regarding disclosure. At the October 31 meeting, Treasury officials reminded participants of their obligation three times. Mr. Davis was also a paid consultant of Goldman Sachs and MFS.

While the embargo was still in effect, Mr. Davis placed nine telephone calls to eight clients including Messrs. Youngdahl and Davis. The call to Mr. Youngdahl was in accord with an earlier agreement between the two men in which Mr. Davis agreed to provide Mr. Youngdahl with information prior to the lifting of the embargo.

Before the embargo was lifted, Goldman Sachs’ Treasury Desk traders purchased $84 million in par value 30 year bonds. Mr. Nothern purchased $25 million in par value of 30 year bonds and tipped three MFS portfolio managers who purchased an additional $40 million in par value 30 year bonds. When the news of the suspension was released, the price of the bonds skyrocketed. Goldman sold the bonds for almost $1.6 million in profits. Mr. Nothern and the other MFS portfolio managers made profits of $3.1 million for the portfolios they managed. The complaint, which alleged violations of Exchange Act Section 10(b) and Rule 10b-5, sought permanent injunctions, disgorgement and civil penalties.

The Commission also brought actions against Goldman Sachs and MFS. In the Matter of Goldman, Sachs & Co., Adm. Proc. File No. 3-11240 (Sept. 4, 2003); In the Matter of Massachusetts Financial Services Company, Adm. Proc. File No. 3-112411 (Sept. 4, 2003). Generally, each Order alleged a failure to establish and enforce adequate policies and procedures to prevent the misuse of material nonpublic information.

Goldman settled, undertaking to pay disgorgement and prejudgment interest of approximately $1.7 million in bond trading profits and prejudgment interest and a penalty of $5 million. The firm also agreed to disgorge about $2.5 million in bond futures trading profits and prejudgment interest. Goldman’s legal department was directed to review and make appropriate recommendations which would be adopted to supplement its procedures. MFS undertook to reimburse the broker-dealer that sold it the 30-year bonds $717,858, representing the losses suffered by the broker dealer along with prejudgment interest. The firm also agreed to the entry of a censure and to pay a civil money penalty of $200,000. The MFS’ general counsel was directed to evaluate and provide suitable supplements for the firm’s procedures.

Subsequently, the SEC voluntarily dismissed its claims against Mr. Nothern. At the time the Commission announced that, it retained the right to file charges against him based on or including the original claim. While noting that its investigation was continuing, the Commission offered no explanation for the dismissal.

At about the same time, Mr. Youngdahl resolved the Commission’s case and a parallel criminal action. In the SEC’s case, Mr. Youngdahl consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions. He also agreed to pay a civil penalty of $240,000. In the parallel criminal case Mr. Youngdahl pleaded guilty to criminal securities fraud charges. See also Litig. Rel. 18453 (Nov. 12, 2003).

Mr. Davis was also charged in a criminal case. U.S. v. Davis, No. 1:03-cr-01054 (S.D.N.Y. Filed Sept. 3, 2003). He pleaded guilty to three felony charges and was sentenced to two years probation and a $30,000 fine on each count. Previously, Mr. Davis had settled with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b) and Rule 10b-5. He also agreed to the entry of an order requiring him to disgorge $29,598 which is the consulting fees he received from Goldman and MFS plus prejudgment interest and to pay a penalty of $120,000. See also Litig. Rel. 18322 (Sept. 4, 2003).

What is clear after years of investigation and litigation is this: The SEC charged three men with an insider trading scheme. It settled with all three. The Government charged two of the three SEC defendants with criminal violations of the law. Both pleaded guilty.

What is not known is the reason one SEC defendant was not charged with criminal violations. What is all too frequently unknown in securities fraud cases, is the line between civil and criminal charges.